1919 


Federal  Income 


and 

War  Tax  Laws 


'i 


HALSEY,  STUART  8c  CO. 

INCORPORATED-SUCCESSORS  TO 

N.  W.  HALSfcY  6c  CO.,  CHICAGO 


1919 

FEDERAL  INCOME 


AND 


WAR  TAX  LAWS 


►*/* 


-A 


HALSEY,  STUART  &  CO. 


incorporated  -Successors  to 


N.  W.  HALSEY  8e  CO.,  CHICAGO 


CHICAGO 

tOt  S  LA  SALLE  ST. 


DETROIT 

FORD  BLDG. 


NEW  YORK 

48  WALL  STREET 

ST  LOUIS 

SECURITY  BLDG. 


PHILADELPHIA 

LAND  TITLE  BLDG. 


BOSTON 

30  STATE  ST. 


MILWAUKEE 

FIRST  NAT  L  BANK  BLDG 


Copyright  1919 
By 

KixMiller  and  Baar 


39165 


HILLISON  &  ETTF.N  COMPANY 
PRINTERS  AND  BINDERS 
CHICAGO 


■p  -  HT4-US^ 

h  yp[ 

CONTENTS  Page 

The  War  Tax  Law .  5 

Title  1.  The  Income  and  War  Excess  Profits  Taxes .  (i 

1.  Tax  Rates,  Exemptions,  and  Application .  6 

1.  Individuals .  6 

Individual  Income  Tax  Table .  8 

Illustration  of  Computation  of  Net  Income  and  Income  Tax  of 

Husband  and  Wife .  11 

2.  Corporations  and  Associations .  13 

Illustrations  of  Computation  of  Invested  Capital  and  Net  Income 

of  Corporation .  14 

Illustrations  of  Computation  of  Corporation  Taxes .  15 

3.  Estates  and  Fiduciaries .  22 

4.  Partnerships .  23 

2.  Determination  of  Invested  Capital .  23 

3.  Determination  of  Net  Income .  29 

(A)  Items  Not  Included  in  Gross  Income .  32 

(B)  Particular  Items  of  Gross  Income . , .  35 

Salaries,  Wages,  Commissions,  Fees,  etc . * .  35 

Trades,  Businesses,  Commerce .  37 

Sales  of  Property .  40 

Interest  Received .  44 

Dividends _ • .  45 

Income  From  Other  Sources .  40 

(C)  Deductions  From  Gross  Income .  50 

Expenses  of  Carrying  on  Business .  50 

Interest .  50 

Taxes .  60 

Losses .  61 

Depreciation .  65 

Amortization  of  War  Plants .  6S 

Depletion  of  Natural  Resources .  60 

Contribution  to  Charities .  70 

4.  Returns  and  Payment  of  Tax .  71 

5.  Information  and  Payment  at  Source .  74 

6.  Illustrative  Cases  .  75 

Individual  Income  Tax .  75 

Corporation  Income  and  Profits  Tax .  78 

Title  II.  Capital  Stock  Tax .  .  82 

Title  III.  Miscellaneous  War  Taxes .  85 

Transportation  and  Communication .  85 

Insurance .  85 

Excise  Taxes  .  85 

Admissions .  86 

Dues .  86 

Federal  Estate  Tax .  87 

Special  Taxes .  88 

Soft  Drinks .  88 

Child  Labor  Tax . 88 

Leasing  Motion  Pictures .  88 

Stamp  Taxes .  80 


* 


* 

. 

I  '  ■  ■ 

?  >  .  ;•<  ■  ? 


'v.  •  • 


i 


■ 

• 

> 

THE  WAR  TAX  LAW. 


1.  The  Kevcnue  Act  of  1918,  enacted  in  February,  1919,  collects  and 
codifies,  with  important  additions  and  amendments,  all  the  federal  legisla¬ 
tion  providing  for  special  war  taxes  and  for  the  taxation  of  incomes  and 
profits.  The  law  deals  with  several  distinct  subjects  of  taxation,  each  of 
which  is  discussed  in  a  separate  title  in  this  book.  It  is  properly  styled 
the  War  Tax  Law,  because  of  the  very  high  rates  of  tax  imposed  and  the 
wide  field  of  subjects  covered,  both  these  features  being  directly  due  to 
the  extraordinary  need  for  revenue  resulting  from  the  war.  The  end  of 
the  war,  however,  does  not  bring,  even  remotely,  the  end  of  the  taxes  im¬ 
posed  by  the  present  law,  although  undoubtedly  many  special  fields  will 
be  abandoned  and  many  rates  will  be  from  time  to  time  materially  re¬ 
duced.  Certainly  income  taxes,  and  probably  excess  profits  taxes,  will 
continue  to  be  an  established  part  of  the  fiscal  system  of  the  federal 
government  and  the  rates  can  not  be  expected  to  return  to  the  prewar 
standards. 

2.  Previous  Legislation.  The  War  Taxes  are  in  many  respects  sim¬ 
ilar  to  those  imposed  in  Civil  War  times  and  again  resorted  to  because 
of  emergency  in  1898  and  1914.  Income  taxes  w^ere  levied  at  the  time 
of  the  Civil  War  but  the  present  system  really  began  in  1909,  with  the 
tax  on  corporation  incomes  which  was  designed  to  supplement  the  re¬ 
duced  tariff.  In  1913,  after  the  adoption  of  the  Sixteenth  Amendment 
removing  certain  constitutional  restrictions  upon  income  taxation,  a  gen¬ 
eral  law  was  adopted  taxing  individuals  as  well  as  corporations.  This 
was  revised  and  extended  by  the  Revenue  Law  of  1916,  and  again  by 
the  Revenue  Law  of  1917,  which  introduced  the  Excess  Profits  Tax. 
Stamp  taxes,  special  occupation  taxes,  excise  taxes,  and  the  capital 
stock  tax,  were  adopted  in  1914,  1916,  and  1917,  along  lines  used  in 
previous  laws.  All  these  taxes,  and  the  new  War  Profits  Tax,  are  re¬ 
enacted  by  the  1918  law,  with  increases  in  rates  and  with  many  addi¬ 
tional  features.  The  present  law  has  therefore  many  of  the  features 
developed  under  the  old  laws  and  will  be  governed  in  its  interpretation 
and  administration  by  the  Regulations  of  the  Treasury  Department  and 
the  judicial  decisions  under  the  former  laws,  upon  which  this  volume 
is  based. 

3.  Rulings  of  the  Treasury  Department.  The  administration  of  the 
Revenue  Law  is  in  the  hands  of  the  Treasury  Department  and  the  Bureau 
of  Internal  Revenue.  The  Secretary  of  the  Treasury  and  the  Commis¬ 
sioner  of  Internal  Revenue  are  expressly  authorized  to  make  rules  and 
regulations  to  carry  out  the  provisions  of  the  law  and  collect  the  tax. 
These  rulings  are  promulgated  either  as  decisions  of  particular  questions 
or  instructions  on  particular  subjects,  known  as  Treasury  Decisions,  or 
as  numbered  Regulations  which  cover  an  entire  branch  of  the  law  and 
provide  general  instructions  for  its  administration.  These  may  be  se¬ 
cured  from  local  collectors.  In  addition,  instructions  to  collectors  and 
revenue  agents  are  issued  in  other  forms  and  letters  of  advice  are 
addressed  to  taxpayers,  many  of  these  being  made  public  through  unofti- 
eial  channels.  The  law  also  creates  an  Advisory  Board  to  assist  in  the 
interpretation  and  administration. 


5 


THE  INCOME  AND  PROFITS  TAXES 


0 


4.  Effect  of  Rulings.  Within  the  limits  of  the  authority  conferred, 
the  regulations  have  all  the  force  and  effect  of  law  and  are  binding  upon 
the  taxpayer  to  the  same  extent  as  the  statute  itself.  But  the  regula¬ 
tions  have  no  force  beyond  that  which  is  derived  from  the  law  as 
enacted  by  Congress.  A  taxing  statute  must  be  strictly  construed,  and 
the  regulations  may  not  lawfully  extend  the  operation  of  the  tax  beyond 
that  which  is  definitely  imposed  by  Congress  in  the  particular  language 
used  in  the  law.  Where  this  is  attempted,  the  taxpayer  is  entitled  to 
relief  in  the  courts.  Except  where  an  appeal  to  the  courts  is  contem¬ 
plated,  the  taxpayer  must  conform  to  the  rulings  of  the  Treasury  De¬ 
partment,  and  the  advice  given  in  this  book  is  directed  to  that  end. 
The  few  cases  where  the  position  taken  in  the  text  differs  from  that  of 
the  Treasury  Department  are  expressly  designated.  Rulings  issued  after 
the  publication  of  this  book  are  contained  in  the  War  Tax  Bulletin 
Service  provided  by  the  publisher,  in  which  all  necessary  modifications 
of  the  text  are  pointed  out. 

TITLE  1.  THE  INCOME  AND  WAR  EXCESS  PROFITS  TAX. 

5.  The  Income  Tax  is  levied  upon  individuals,  corporations,  busi¬ 
ness  trusts  and  associations,  and  estates  of  certain  kinds,  but  not  upon 
partnerships.  The  War  Profits  Tax  and  Excess  Profits  Tax  apply  only 
to  corporations  and  associations  (except  where  an  individual  or  partner¬ 
ship  elects  to  be  taxed  as  a  corporation,  as  explained  at  par.  31).  These 
taxes  are  all  based  upon  the  “Net  111001116”  which  is  defined  in  the  law, 
as  discussed  under  a  separate  heading  in  this  book,  and  are  assessed  upon 
sworn  Returns  which  it  is  the  duty  of  each  taxpayer  to  file  annually. 

PART  1.  TAX  RATES,  EXEMPTIONS,  AND  APPLICATION. 

1.  Individuals. 

0.  Persons  Subject  to  the  Tax.  The  Income  Tax  is  not  limited  to 
income  from  business,  but  applies  to  every  person  receiving  from  any 
source  "whatever  a  net  income  in  excess  of  the  exemptions.  Not  only 
citizens  and  aliens  residing  in  the  United  States,  but  also  nonresident 
aliens  receiving  income  from  this  country  and  citizens  residing  abroad, 
without  regard  to  the  source  of  their  income,  are  covered  by  the  law. 
Married  women  and  persons  not  arrived  at  legal  age  are  taxed. 

7.  The  Personal  Exemption.  Every  individual  receives  a  “personal 
exemption”  upon  which  no  income  tax  is  paid,  in  the  following  amounts: 
Husband  and  wife,  living  together,  •  from  their  aggregate  net  income. 
$2,000;  head  of  a  family,  $2,000;  single  person,  $1,000;  for  each  dependent 
(not  husband  or  wife)  under  18  years  of  age  or  incapable  of  self  sup 
por  t,  in  addition,  $200. 

8.  Credit  for  Dividends  and  Exempt  Interest.  In  computing  the 

normal  tax,  credit  is  allowed,  as  shown  in  the  illustration  on  page  11. 
and  as  more  fully  explained  at  pars.  110  and  72  of  the  text,  for  divi¬ 
dends  received  upon  stock  of  a  corporation  which  is  itself  subject  to  the 
Income  Tax  Law,  and  for  interest  received  upon  partly  tax  exempt 
bonds.  This  is  after  determining  the  net  income  and  is  altogether  dif- 


THE  INCOME  AND  PROFITS  TAXES 


ferent  from  the  deductions  made  for  that  purpose.  These  credits  do 
not  apply  in  computing  the  surtax. 

9.  The  Normal  Tax.  The  Income  Tax  on  individuals  includes  two 
taxes  computed  by  different  methods.  There  is  a  tax  which  applies  at 
the  same  rate  to  every  individual.  This  is  the  Normal  Tax.  The  rates 
are:  $4,000  of  Net  Income  (in  excess  of  exemptions  and  credits) — 1918, 
6%  -subsequent  years,  4 %;  remainder  of  Net  Income — 1918,  12% — sub¬ 
sequent  years,  8%.  For  example,  a  single  person,  not  the  head  of  a 
family,  will  pay  no  normal  tax  on  the  first  $1,000  of  his  net  income,  6 %> 
on  the  next  $4,000,  and  12%>  on  all  the  remainder,  whether  his  net  income 
is  $10,000  or  $200,000.  If  his  net  income  is  $6,000,  his  normal  tax  will  be 
$:;60.  In  addition,  he  will  pay  a  surtax. 

10.  The  Surtax.  If  the  net  income  of  an  individual  exceeds  $5,000, 
it  is  subject  to  the  surtax,  which  is  at  different  rates  on  successive 
parts  of  the  income,  increasing  rapidly  as  the  income  grows  larger.  The 
personal  exemption  is  not  used  to  compute  this  tax.  For  example,  if  tin1 
net  income  exceeds  $5,000,  the  surtax  will  amount  to  1%  on  the  excess 
up  to  $1,000  or  a  net  income  of  $6,000.  If  the  net  income  is  greater 
than  $6,000,  the  excess  up  to  $8,000  is  taxed  2%,  and  a  higher  rate  is 
imposed  on  each  succeeding  part  of  the  net  income,  increasing  by  1  % 
for  each  $2,000  up  to  $100,000  and  then  by  greater  steps  to  65%.  The 
Income  Tax  Table  on  page  8  shows  all  the  rates  of  surtax  and  a  con¬ 
venient  method  of  computation. 

11.  Returns  Required.  An  annual  Return  (Form  1040),  showing  in 

detail  the  gross  income  and  the  net  income  for  the  calendar  or  fiscal 

year,  must  be  filed  by  every  single  person  receiving  a  net  income  of 

$1,000  or  over  during  the  year,  even  though  the  head  of  a  family  or  for 

any  other  reason  not  subject  to  tax,  and  by  every  married  person  living 

with  husband  or  wife  where  the  husband  and  wife  receive  an  aggregate 

net  income  of  $2,000  or  over  during  the  year.  The  Return  must  be 

filed  with  the  Collector  of  Internal  Revenue  for  the  district  in  which 

the  taxpayer  resides  or  has  his  principal  place  of  business,  on  or  before 

March  fifteenth  of  each  year  or  within  two  months  and  fifteen  davs  fol 

•  •/ 

lowing  the  close  of  the  fiscal  year.  (For  further  discussion  of  the  Re- 
Turn,  see  pars.  185-188). 

12.  Head  of  a  Family.  Where  one  person  actually  supports  one  or 
more  other  related  persons  either  in  whole  or  in  part,  as  a  legal  or 
moral  obligation,  he  is  for  tax  purposes  the  head  of  a  family  and  lias 
an  exemption  of  $2,000  from  the  normal  tax.  For  each  dependent 
person  (except  husband  or  wife)  under  18  years  of  age  or  incapable  of 
self-support  because  mentally  or  physically  defective,  the  head  of  a 
family  has  an  additional  exemption  of  $200.  For  example:  Harley  Cot¬ 
ton,  a  widower,  has  an  adopted  son  16  years  old  and  two  daughters  19 
and  15  years  old,  respectively,  whom  lie  is  supporting.  His  net  income 
is  $4,500,  so  his  income  tax  will  be  6%  upon  $2,100,  or  $126. 

15.  Combined  Incomes  of  Married  Persons.  A  Return  by  the  hus 
band  or  wife  is  required  if  the  combined  net  income  of  husband  and 
wife  (living  together)  is  $2,000  or  more.  If  a  man  earns  $1,100  and 
his  wife  earns  $600,  no  Return  is  due,  but  a  Return  must  be  filed  if  he 
has  a  net  income  of  $1,800  and  she  has  a  net  income  of  $600.  Tf  the 
wife  has  a  separate  net  income,  a  Return  by  her  is  required;  this  may  be 


s 


THE  INCOME  AND  PROFITS  TAXES 


INDIVIDUAL  INCOME  TAX  TABLE 

Showing  Total  Tax  and  Convenient 
Method  of  Computation 

Begin  at  the  first  column  with  the  largest  amount  which  is  included  in  your  net  income  and 
read  across  the  page. 

The  figures  given  are  for  a  single  person  with  a  personal  exemption  of  $1,000,  not  receiving 
any  dividends  or  exempt  interest. 

For  a  married  person  or  the  head  of  a  family,  find  the  total  tax  according  to  the  table,  and 
then  deduct:  $120  and  $24  additional  for  each  dependent  other  than  husband  or  wife,  where  the 
net  income  exceeds  the  total  personal  exemption  by  $4,000  or  more;  $60  and  $12  additional  for  each 
■<uch  dependent  if  the  net  income  is  between  the  personal  exemption  and  $5,000.  If  the  net 
income  does  not  come  in  either  of  these  classes,  compute  the  tax  without  using  the  table. 

If  the  net  income  includes  any  dividends  or  interest  which  is  subject  to  surtax  only, 
from  the  amount  shown  by  the  table  deduct:  12  per  cent  of  the  amount  of  such  partially  exempt 
income  if  the  remaining  net  income  exceeds  the  personal  exemption  by  $4,000  or  more;  0  per 
cent  of  such  amount  if  the  net  income  including  the  partially  exempt  income  is  less  than  $4,000 
in  excess  of  the  personal  exemption.  If  the  net  income  does  not  come  in  either  of  these  classes, 
compute  the  tax  without  using  the  table. 


Net 

Normal 

Surtax 

Total 

Tax  on  Additional  Net 

Income 

Income 

Tax 

Tax 

From 

To 

Rate* 

$  1,000...  . 

.None. . .  . 

. None.  .  . . 

. None.  .  . . 

.  .$  1,000..  .  . 

. .  .$  5,000... 

•  •  •  6% 

1,500..  .  . 

. None.  .  . . 

.$  30... 

. .  1,500..  .. 

...  5,000... 

•  ■  •  6% 

2,000...  . 

60... 

None.  . . . 

60... 

. .  2,000.... 

...  5,000... 

•  • .  6% 

2,500...  . 

90... 

.  None.  . . . 

90... 

. .  2,500.... 

...  .  5,000... 

. . .  6% 

3,000...  . 

120... 

.  None.  . . . 

120... 

. .  3,000.... 

...  5,000... 

•  •  •  6% 

4,000... . 

180... 

. None.  . . . 

180... 

. .  4,000.... 

...  5,000... 

- . .  6% 

5,000..  . 

....  240... 

. None.  . . . 

240.. 

. .  5,000.... 

...  6,000... 

. .  13% 

6,000... . 

360... 

.$  10... 

370... 

. .  6,000..  .. 

...  8,000... 

. .  14% 

7,000... . 

480... 

30... 

510... 

. .  7,000..  .. 

...  8,000... 

•  ■  •  14% 

7,500... . 

540. . . 

40... 

580... 

. .  7,500..  .. 

...  8,000... 

•  14% 

8,000... . 

600... 

50... 

650... 

. .  8,000..  . 

...  10,000.. 

. .  15% 

9,000.... 

720... 

80... 

800... 

. .  9,000..  . 

...  10,000... 

. .  15% 

10,000..  .  . 

840... 

110... 

950... 

. .  10,000  .. 

. ..  12,000... 

. .  10% 

12,000..  .  . 

.  1,080... 

190... 

.  1,270... 

. .  12,000..  .. 

..  14,000... 

•  ■  •  17% 

12,500... . 

.  1,140... 

215... 

.  1,355... 

. .  12,500..  . 

...  14,000... 

. .  17% 

14,000... . 

.  1,320... 

290... 

.  1,610... 

. .  14,000...  . 

...  16,000... 

...18% 

15,000...  . 

.  1,440... 

350... 

.  1,790... 

. .  15,000... 

...  16,000... 

...18% 

16,000..  . . 

.  1,560... 

410... 

.  1,970... 

. .  16,000.... 

...  18,000... 

...19% 

18,000...  . 

.  1,800... 

550. . . 

.  2,350... 

.  .  18,000..  .  . 

...  20,000... 

•  •  .20% 

20,000.. 

.  2,040... 

710... 

2,750.. 

. .  20,000..  .. 

...  22,000... 

...21% 

22,000... . 

.  2,280... 

890... 

.  3,170... 

. .  22,000.... 

...  24,000... 

•  • .  22% 

24,000...  . 

.  2,520... 

.  1,090... 

.  3,610... 

. .  24,000.... 

...  26,000... 

...23% 

26,000.. 

.  2,640... 

.  1,200... 

3,840.. 

.  .  25,000.... 

...  26,000... 

...23% 

26,000...  . 

.  2,760... 

.  1,310... 

.  4,070.. 

.  .  26,000..  .  . 

...  28,000... 

•  •  .24% 

28,000.. 

.  3,000... 

1,550... 

4,550.. 

.  .  28,000... . 

.  .  30,000.. 

. .  .25% 

The  Surtax  rate  is  12%  less  than  the  rate  shown, which  is  the  combined  Normal  Tax  and  Surtax. 


THE  INCOME  AND  PROFITS  TAXES 


9 


Net 

Normal 

Surtax 

Total 

Tax  on  Additional  Net  Income 

Income 

Tax 

Tax 

From 

To  Rate  * 

30,000  .$ 

3,240... 

$  1,810... 

$  5,050... 

.$  30,000...  . 

32,000. . 

3,480... 

2,090... 

5,570.. . 

.  32,000..  . 

34,000.  .27% 

34,000. . 

3,720... 

2,390... 

6,110... 

.  34,000..  . 

36, 000...  28% 

35,000. . 

3,840... 

2,550.. . 

6,390... 

.  35,000.. 

36,000.  .28% 

36,000. . 

3,960... 

2,710... 

6,670.. . 

.  36,000..  . 

38, 000...  29% 

38,000.. 

4,200... 

3,050.. . 

7,250.. . 

.  38,000.... 

40, 000...  30% 

40,000. . 

4,440... 

3,410... 

7,850... 

.  40.000.. 

42, (XX)  .31% 

42,000. . 

4,680... 

3,790... 

8,470... 

.  42,000.. 

44,000.  .  32% 

44,000. . 

4,920... 

4,190... 

9,110... 

.  44,000..  . 

46, 000...  33% 

46,000. . 

5,160.. . 

4,610... 

9,770... 

.  46,000.... 

48,000.  .34% 

48,000. . 

5,400.. . 

Oj0o0.  • . 

10,450... 

.  48,000.... 

50,000..  .35% 

50,000.. 

5,640... 

5,510.. . 

11,160... 

.  50,000.... 

52, 000...  36% 

52,000. . 

5,880... 

5,990.. . 

11,870... 

.  52,000.... 

54, 000...  37% 

54,000. . 

6,120... 

6,490... 

12,610... 

.  54,000.... 

56, 000...  38% 

56,000. . 

6,360... 

7,010... 

13,370... 

.  56.000.... 

58,000..  .39% 

58,000.. 

6,600.. . 

7,550.. . 

14,150... 

.  58,000.... 

60, 000...  40% 

60,000.. 

6,840... 

8,110... 

14,950... 

.  60,000.... 

62, 000...  41% 

62,000. . 

7,080... 

8,690... 

15,770... 

.  62,000.... 

64, 000...  42% 

(>4,000. . 

7,320... 

9.290... 

16,610... 

.  64,000.. .  . 

66, 000...  43% 

66,000. . 

7,560.. . 

9,910... 

17,470... 

.  66,000.... 

68,000. .  .44% 

68,000. . 

7,800... 

10,550... 

18,350.. . 

.  6S,000.. .  . 

70, 000...  45% 

70,000. . 

8,040... 

11,210... 

19,260... 

.  70,000.... 

72, 000...  46% 

72,000. . 

8,280... 

11,890... 

20,170... 

.  72,000.... 

74, 000...  47% 

74,000.. 

8,520... 

12,590... 

21,110... 

.  74,000.... 

76,000. .  .  48% 

76,000.. 

8,760... 

13,310... 

22,070... 

.  76.000.... 

78, 000...  49% 

78,000. . 

9,000.. . 

14,050.. . 

23,050... 

.  78,000.... 

80, 000...  50% 

80,000.. 

9,240... 

14,810... 

24,060... 

.  80,000.... 

82, 000...  51% 

82,000. . 

9,480... 

15,590.. . 

25,070... 

.  82,000.... 

84,000..  .52% 

84,000.. 

9,720... 

16,390... 

26,110... 

.  84,000.... 

86, 000...  53% 

86,000. . 

9,960... 

17,210... 

27,170... 

.  86,000.... 

88, 000...  54% 

88,000.. 

10,200... 

18,050... 

28,250... 

.  88,000.... 

90, 000...  55% 

90,000. . 

10,440... 

18,910... 

29,350... 

.  90,000.... 

92, 000...  56% 

92,000. . 

10,680... 

19,790... 

30,470... 

.  92,000.... 

94, 000...  57% 

94,000. . 

10,920... 

20,690... 

31,610... 

.  94,000.... 

96, 000...  58% 

96,000.. 

11,160... 

21,610... 

32,770... 

.  96,000.... 

98,000. .  .  59% 

98,000. . 

11,400... 

22,550.. . 

33,950.. . 

.  98,000.... 

100,000.  .  .60% 

100,000.. 

11,640... 

23,510... 

36,160... 

.  100,000.... 

150,000.  64% 

125,000.. 

14,640... 

36,510.. . 

51, 150.. . 

.  125, 000.... 

150,000.  64% 

150,000.. 

17,640... 

49,510... 

67,150.. . 

.  150,000.... 

200,000..  .68% 

175,000.. 

20,640... 

63,510... 

84,1.50... 

.  175,  (XX).... 

200,000. .  68% 

200,000. . 

23,640... 

77,510... 

101,150... 

.  200, (XX).... 

..  300,000..  .72% 

250,000. . 

29,640... 

107,510... 

137,150... 

.  250,000.... 

300,000.  .72% 

300, 000. . 

35,640.. 

137,510... 

173, 150.. . 

.  300.000.... 

500, (XX). .  .  75% 

500,000. . 

59,640... 

263,510... 

323,150... 

.  500,000.... 

..  1,000,000..  .76% 

1.000,000.. 

119,640... 

583,510... 

703,150... 

.  In  excess  of  $1,000,000. .  .77% 

•The  Surtax  rate  is  12°1  less  than  the  rate  shown,  which  is  the  combined  Normal  Tax  and  Surtax. 


10 


THE  INCOME  AND  PROFITS  TAXES 


:i  separate  Return  or  she  may  subscribe  to  the  joint  Return  made  by 
both  the  husband  and  the  wife.  If  the  amount  of  the  wife's  income 
is  small,  it  is  acceptable  if  only  the  husband  signs  the  Return.  The 
Return  should  show  separately  the  income  received  by  each. 

14.  Exemptions  of  Husband  and  Wife.  Husband  and  wife  are  en¬ 
titled  to  only  one  exemption,  to  be  deducted  from  their  combined  in¬ 
comes.  If  the  husband  deducts  the  $2,000  exemption  and  the  allowance 
for  dependent  children  from  his  separate  Return  in  computing  his  nor¬ 
mal  tax,  then  his  wife  who  files  a  separate  Return  is  not  entitled  to  any 
exemption  from  normal  tax.  Therefore,  the  Treasury  Department  re¬ 
quires  that  where  a  husband  and  wife  file  separate  Returns,  they  be 
fastened  together.  Where  one  Return  includes  the  income  of  both  hus¬ 
band  and  wife,  the  exemption  should  be  deducted  from  their  combined 
incomes.  This  personal  exemption  is  designed  to  cover  the  essential 
living  expenses,  and  for  this  reason  is  allowed  only  once  in  a  single 
family.  Where  husband  and  wife  are  not  living  together  they  are  to  be 
created  as  single  persons,  and  each  is  entitled  to  the  $1,000  exemption 
of  a  single  person. 

15.  Married  Woman’s  Return.  A  married  woman  may  make  a 
separate  Return  of  her  own  income,  and  should  do  so  if  the  net  income 
of  her  husband  or  herself  exceeds  $5,000,  as  the  surtax  is  imposed  upon 
the  separate  incomes  and  the  assessment  is  much  more  convenient  upon 
separate  than  upon  combined  Returns.  Apparently  the  12%  rate  ap¬ 
plies  also  to  the  incomes  separately  and  not  combined;  that  is,  both  the 
husband  and  wife  may  each  receive  $4,000  above  the  exemption,  upon 
which  they  pay  only  6%,  before  any  of  the  income  is  taxed  at  1  2%. 
This  law,  however,  is  not  clear  on  this  point  and  the  contrary  interpreta¬ 
tion  may  be  made. 

16.  Illustration:  If  the  net  income  of  the  husband  is  $7,000  and 
that  of  the  wife  is  $2,000,  the  tax  is  as  follows:  Frem  the  husband’s 
income,  $7,000,  take  the  personal  exemption,  $2,000,  and  the  normal 
tax  is  6%  of  the  first  $4,000,  or  $240,  and  12%  of  the  remaining  $1,000, 
or  $120,  making  the  total  normal  tax  of  the  husband  $360.  The  surtax 
of  the  husband  is  1%  of  $1,000,  plus  2%  of  $1,000,  or  $30.  The  wife 
receives  no  additional  personal  exemption,  but  her  entire  net  income 
of  $2,000  is  taxed  at  6%,  being  less  than  $4,000.  Her  normal  tax  is  thus 
$120,  and  she  is  not  subject  to  surtax.'  The  combined  tax  of  husband 
and  wife  is  $510  on  an  aggregate  income  of  $9,000.  See  also  Illustra¬ 
tion  on  opposite  page. 

17.  Exemptions  to  a  Deceased  and  Surviving  Spouse.  A  married 
man  dies  in  1918.  His  executor  must  make  a  Return  of  the  income  he 
received  during  1918  up  to  the  date  of  his  death,  and  may  deduct  there¬ 
from  the  exemption  of  $2,000.  This  situation  does  not  appear  to  be 
covered  bv  the  provision  for  reducing  the  exemption  when  the  Return 
covers  less  than  twelve  months  because  of  a  change  in  the  fiscal  year. 
The  surviving  wife  must  make  a  Return  of  the  income  she  has  received 
during  the  calendar  year,  and  may  deduct  therefrom  the  exemption 
of  $1,000. 

18.  Exemption  Fixed  by  Status  at  the  End  of  the  Year.  The 

status  of  the  taxpayer,  for  the  purpose  of  the  exemption,  is  determined 


THE  INCOME  AND  PROFITS  TAXES 


11 


4> 

rta 

£ 


9 

8 

»  § 

1  ^ 

as 

£ 

8 

QO 

8 

to 

1 

h! 

8 

E  . 

»o 

Cl 

1 

Cl 

None 

cd 

s 

N 

£ 

(N 

00 

cd 

Cl 

3 

-<r 

** 

«• 

51 

•  ««* 

t% 

s 


co 

w 


a 

H 

o> 

6 

o 

O 

G 


® 

a 

s 

P— l  o 

C 

M 

T3  ^ 
® 

2 


^  O  ^  ^ 

a88e 

iiii 


9 


a 

H 

■3 

a 

u 

o 

fc 


trt 

4-> 

1 

t- 

o 


a 

£ 

M 

ci 


a 

o  a  ® 

'3Jt 
a  g  a 

hi 

rg'C^ 
a<  u  e  - 
—  es  ST3  — 
jj  C  If  C  . 

a  «  a>  £ 

o  fe  <- 

|^c2:e^ 

& 


^  S? 

88 

Ci  ?  S 

o  w 

—  h. 

Cl  Ot 

v» 

!  s*.  ^  .  cs  kOvd 

t^ 

*> 

•o 

e 

o 

ss 


•2 

U 

3 

c 

E» 


x 

as 

H 

"a 

a 

u 

O 

£ 

o 


XJ 

3 

<n 

a 

a 

8 

c 


0) 

X 


a 

H 

"a 

a 

u 

O 

5^, 

2 

4-> 

8 

X 

3 

or. 

O 

13 


O 

u 

a 

o 

Cl 

a 

>—i 

« 

* 


e 

c 

o 

2 
t 

Cl 

x 

3 

OD 

T3 
C 
a 
x 

5 
K 

O 
© 

a 

o 
© 

G  y 

^  s 

*■*  L* 
©  ^ 


9 

t 

3 

CO 

Q 


.c 

3 

oo 

O 


O 

a 

a 

o 

o 

a 


a 


a 

t 

G 

X 

c 


© 
© 
•  -1 

X 

3 

<r. 

T 

C 

a 

X 

r. 


o 

a 

a 

o 

o 

B 

t— i 
*- 
O 

!Z 


x 

a 

a 

a 

u 

O 

Z 


ts 

CD 

® 


o 

a 

a 

o 

B 

a 

i— < 

a 

/C 

c 

O 


6^ 

O  <M 

f— * 

<s>® 

8  fe 


»>■  hr* 
-  — 


”2  ^  oo 
c 
a 
X) 

ai 
3 


O 

a 

a 

o 

© 

G 


t^. 

Oi 

CO 

O 


+■*-*->  r-« 

©  00  S 

55 .5  J 


c 
c 

X 

a 
H 
3 

a 

E 
O 

£ 
a  ~ 


c 


"0 

a 

£ 

8 


X 

a 

+-» 

a 

o 

8 

*- 

G 

8 

*- 

a 

'3 

a 


-a 

a 

u 

O 


c 

3 

*C 

x 

a 

E- 

*3 

a 

L- 

o 


£ 

a 

a 


Cu 

t- 

So 

§0O 

.§ 

Or-* 


h-  I  - 
05  03 


a 

t 

a 

CO 


bC 

a 

’3 

a 

a 

« 

u 

a  a 
OO 


o 

8 


a 

o 

x 


u  a 

a  t 


3 

CO 


a 

c 

X 

a 

« 

a 

o 

o 

C 


a  a 

2  2 

H  a 

o 

H 


THE  INCOME  AND  PROFITS  TAXES 


as  of  December  31  of  the  year  for  which  the  Return  is  made.  A  man 
who  marries  on  December  30  is  entitled  to  deduct  the  full  amount  of  the 
exemption  applicable  to  the  head  of  a  family. 

JO.  Minors,  A  parent  may  include  in  his  Return  the  income  of  de- 
peudent  minor  children.  Compensation  earned  by  such  children  is  income 
,»f  Die  parent.  As  to  such  income,  there  is  no  personal  exemption  for  the 
minor.  A  minor  receiving  income  from  property  held  as  his  separate 
estate  or  compensation  for  his  services  after  his  emancipation,  or  other 
income  not  subject  to  appropriation  by  his  parent,  must  file  a  separate 
Return  and  may  claim  a  separate  exemption. 

20.  Nonresident  Aliens.  A  citizen  or  subject  of  a  foreign  country 
who  does  not  reside  in  this  country  is  a  nonresident  alien  and  is  taxed 
upon  the  income  received  from  sources  in  this  country.  An  alien  resid¬ 
ing  in  the  United  States  and  a  citizen  residing  abroad  are  taxed  upon 
their  entire  income,  including  that  received  from  foreign  sources.  Citi¬ 
zenship  is  conferred  only  by  completed  naturalization,  not  by  so-called 
“first  papers.  ”  An  alien  is  not  a  nonresident  if  he  has  made  his  home 
in  this  country  and  has  no  intention  of  returning  to  any  former  home, 
but  if  he  is  temporarily  living  in  the  United  States,  intending  to  leave 
it  at  some  indefinite  time  or  upon  the  termination  of  the  purpose  for 
which  he  came  here,  he  is  a  nonresident  alien.  From  the  income  re¬ 
ceived  from  sources  in  this  country,  a  nonresident  alien  is  allowed 
deductions  similar  to  those  allowed  to  residents,  but  only  to  the  extent 
that  they  are  connected  with  property  in  this  country  or  income  received 
from  this  country,  and  only  if  he  files  a  Return  giving  all  the  information 
required  by  the  Commissioner.  The  personal  exemptions  of  $1,000  or 
$2,000  shall  not  be  allowed  if  the  country  of  which  the  nonresident 
alien  is  a  citizen  or  subject  imposes  an  income  tax  and  does  not  allow  a 
alien,  thought  to  be  a  nonresident,  denies  that  he  is  subject  to  such 
country.  Nonresident  aliens  do  not  receive  the  benefit  of  the  lower 
rate  of  normal  tax  applicable  to  the  first  $4,000  of  taxable  net  income, 
but  the  higher  rate  only  is  used.  Every  person  in  this  country  paying 
salary,  rent,  interest,  or  other  fixed  or  determinable  annual  or  periodical 
income  (except  dividends  or  interest  on  tax  free  bonds)  to  a  nonresident 
alien  must  withhold  and  pay  a  tax  of  8%  on  such  income.  Where  an 
alien,  thought  to  be  a  nonresident,  denies  that  he  is  subject  to  such 
withholding,  he  may  be  required  to  execute  a  certificate  (Form  1078) 
which  will  protect  the  employer  or  other  person  in  paying  income  in  full. 

2.  Corporations  and  Associations. 

21.  Definition.  The  term  “corporation”  refers  not  only  to  the 
ordinary  statutory  corporations  but  also  to  business  trust  associations, 
called  “Massachusetts  Trusts,”  joint  stock  companies,  limited  partner¬ 
ships,  mutual  savings  banks  and  insurance  companies,  and  all  analogous 
business  associations,  the  net  income  of  which  is  distributed  among  the 
members  on  the  basis  of  the  shares  which  each  holds  or  the  proportion  of 
capital  which  each  has  invested.  (For  “personal  service”  corporations, 
see  par.  30).  Corporations  organized  in  this  country  are  taxed  upon 
their  income  received  from  all  sources;  corporations  organized  in  for¬ 
eign  countries  are  taxed  upon  the  net  income  received  from  sources  in 
this  country  only. 


THE  INCOME  AND  PROFITS  TAXES 


13 


22.  Kinds  of  Taxes  on  Income.  The  net  income  of  a  corporation  is 
subject  to  two  distinct  taxes,  the  Profits  Tax  aiul  the  Income  Tax. 
involving  four  different  plans  of  taxation,  each  plan  with  different  rates, 
exemptions,  credits,  and  methods  of  computation.  The  Profits  Tax  is  a 
combination  of  an  Excess  Profits  Tax,  directed  at  the  excess  over  a 
fixed  return  upon  the  invested  capital,  and  a  War  Profits  Tax  based  upon 
the  difference  between  the  income  of  the  prewar  years  and  that  of  the 
current  taxable  years.  The  Profits  Tax  equals  the  greater  of  the  two 
amounts,  except  that  it  may  not  exceed  a  maximum  determined  at  a 
fiat  rate  upon  a  different  plan,  which  is  explained  as  the  third  method. 
The  Income  Tax,  which  is  the  fourth  method,  is  levied  at  a  fiat  rate 
upon  the  taxable  income  in  excess  of  the  stated  exemptions.  Every 
corporation  must  ascertain  its  liability  with  respect  to  all  four  of  these 
methods  of  taxation,  although  only  one  Profits  Tax  is  finally  assessed 
after  the  method  of  computation  which  is  applicable  has  been  selected. 
The  Income  Tax  is  in  addition  to  the  Profits  Tax.  Lower  rates  are  fixed 
for  1919  and  subsequent  years,  except  that  any  corporation  which 
receives,  in  any  year  after  1918,  net  income  of  $10,000  or  more  from 
government  contracts  made  between  April  6,  1917,  and  November  11, 
1918,  inclusive,  shall  be  subject  to  the  1918  Profits  Tax  upon  such  income. 
The  following  table  shows  the  rates  which  apply  to  the  income  of  1918 
and  also  of  1919  and  subsequent  years.  See  also  the  Illustrations  at 
page  14,  which  show  the  method  of  computation. 

Profits  Tax:  CORPORATION  TAX  RATES  Subsequent 

Method  1.  Excess  Profits  Tax.  1918  years. 

Excess  Profits  Credit  (par.  2d) . Not  taxed.  Not  taxed. 

First  Bracket — Net  Income  in  excess  of 
Credit  and  not  in  excess  of  20%  of 
Invested  Capital  . .• .  30% 

Second  Bracket — Remainder  of  Net  Income  05% 

Method  2.  War  Profits  Tax. 

Third  Bracket — The  Excess  Profits  Tax  is 
deducted  from  the  War  Profits  Tax,  and 
the  difference  is  the  Third  Bracket  of 
the  Profits  Tax.  This  Bracket  applies 
only  where  the  War  Profits  Tax  is  greater 
than  the  Excess  Profits  Tax,  in  which 
event  the  total  of  the  three  Brackets  will 
equal  the  War  Profits  Tax. 

War  Profits  Credit  (par.  24) . Not  taxed. 

Remainder  of  Net  Income .  80% 

Method  3.  Maximum  Profits  Tax. 

Applies  when  less  than  the  amount  found 
by  above  method. 

Net  Income  between  $3,000  and  $20,000....  30% 

Net  Income  in  excess  of  $20,000 .  80% 

Income  Tax: 

Method  4.  Income  Tax.  In  addition  to  the 
Profits  Tax. 

Income  Tax  Credit  (par.  26) . Not  taxed.  Not  taxed. 

Remainder  of  Net  Income .  12%  10% 


20% 

40% 


No 

War 

Tax 

Profits 

after 

1918. 


20% 

40% 


14 


THE  INCOME  AND  PROFITS  TAXES 


ILLUSTRATION  OF 

Computation  of  Invested  Capital  and  Net  Income 

OF  CORPORATION 

INVESTED  CAPITAL 

Capital  and  Surplus: 

Capital  stock,  paid  up  and  outstanding  March  3,  1917,  and  January 

1,  1918 . $900,000.00 

Surplus,  January  1,  1918  .  450,000.00 

Undivided  profits,  January  1,  1918 .  106,926.50  $1,456,926.50 

Adjustments: 

Cash  paid  in  for  stock,  S100.000  at  par. 

Bonus  stock  given  with  stock  sold  for  cash . $100,000.00 

Tangible  property  paid  in  for  stock: 

Par  value  of  stock  issued . .  $200,000.00 

Actual  value  of  property  when  acquired .  150.000.00  50.000.00 

Intangible  property  paid  in  for  stock: 

Par  value  of  stock  issued  for  all  property  of  a  going 

business  in  1905 . $500,000.00 

Proved  value  of  tangible  property .  150,000.00 

Par  value  of  stock  issued  for  good  will  and  patents ....  $350,000.00 
Actual  value  when  acquired  ($600,000) 

25%  of  outstanding  capital  stock  .  175,000.00  175,000.00  $  325,000.00 

Invested  capital  at  beginning  of  year . . . $1,131,926.50 


Changes: 

Dividend  paid  February  20,  1918,  $45,000  for  10  1-3  months .  37,500.00 

Dividend  paid  August  20,  1918,  $45,000,  covered  by  current  profits. 

Average  for  year . $1,004,426.50 


Inadmissible  Assets: 

Total  assets,  average  for  year . $2,873,528.00 

Inadmissible  assets,  average  for  year .  563,296.00 

Ratio  of  inadmissible  assets  to  total  assets .  .  . . , .  19.6% 

Deduction  of  19.6%  of  average  invested  capital .  214,507.51 


Invested  Capital,  admissible  average . . .  .$  879,918.99 


NET  INCOME 

Gross  Income: 

Sales . $1,545,214.00 

Interest  on  bank  balance .  350.00 

Interest  on  corporate  bonds .  2,464.00 

Interest  on  Liberty  Bonds: 

Third  Loan  (S32.500  held,  $12,500exempt),  first  coupons  on  $20,000.  298.00 

Fourth  Loan  ($5,000  held),  no  interest  received. 

Dividends  from  other  corporations.  Exempt.  - 

$1,548,326.00 


Deductions: 


Net  cost  of  goods  sold . $  619,592.00 

Expenses .  186,725.36 

Interest  paid .  192,317.00 

Losses  on  bad  debts,  sale  of  permanent  assets,  etc .  18,462.00 

Depreciation .  41,690.00 

Taxes  (excluding  $91,430  Federal  income  tax  paid) .  17.473.00 


$1,076,259.36 
.$'  472,066.04 


Net  Income 


THE  INCOME  AND  PROFITS  TAXES 


15 


Illustrations  of  Computation  of  Corporation  Taxes 

CASE  1— EXCESS  PROFITS  TAX 

Net  income  for  1918  (see  opposite  page  for  computation) . 

Invested  capital  (see  opposite  page  for  computation) . 


Invested  capita)  for  prewar  period:  1911 . . $  498,180  66 

1912  .  533.S96.00 

1913  .  .  678,756.00 


Total  and  average . $1,710,832.00 

Increase  in  invested  capital . 

Net  income  for  prewar  period:  1911 . $  342,762  66 

1912  .  481.290.00 

1913  .  512,687.00 


$472,066.64 
879,918  90 


$570,277.33 

$309,641.57 


Total  and  average 


SI, 336, 739.00  $445,579.67 


Method  1. — Excess  Profits  tax:  Income  Rate 

Specific  exemption.  . . * . S  3,000.00 

8%  of  Invested  capital .  70,393.51 


Tax 


Excess  profits  credit . $  73,393.51 

Above  credit  and  under  20%  of  Invested  capital  (S175.9S3.78) _  102,590.27  30% 

Above  20%  of  invested  capital .  296,082.86  65% 


$  30,777.0s 
192,453.86 


Method  2. — War  Profits  Tax: 

Specific  exemption .  .  . .  ? . $  3,000.00 

10%  of  invested  capital  ($87,991.89) 

Prewar  Income .  445,579.67 

10%  of  increase  in  invested  capital .  30,964.15 


*223,230.94 


War  profits  credit . $479,543.82 

No  income  subject  to  War  Profits  Tax. 


Method  3. — Maximum  Profits  Tax: 

Specific  exemption . 

Between  $3,000  and  $20,000 . 

Over  $20,000 . 


S  3,000.00 

17,000.00  30%  S  5,100.00 
452,066.64  80%  361,653.31 


(Maximum  does  not  apply) . $472,066.64 

Method  4. — Income  Tax: 

Exempt  Liberty  Bond  interest . $  298.00 

Specific  exemption .  2,000.00 

Credit  for  profits  tax .  223,230.94 

Remainder  of  net  income .  246,537.70 


$366,753.31 


12%  $  29,584.52 


Total  Income  and  Profits  Tax 


$472,066.64 


$252,815.46 


CASE  2— WAR  PROFITS  TAX 


Net  income  for  1918 . $1,167,677.02 

Invested  capital  for  1918 .  2,207,517.04 

Average  annual  net  income  for  prewar  period .  69,346.97 

Average  invested  capital  for  prewar  period . .  . . . . .  1,788,558.37 

Increase  in  invested  capital  since  prewar  period . *. . . .  418,958.67 


Method  1. — Excess  Profits  Tax:  Income  Rate 

Specific  exemption . . $  3,000.00 

8%  of  Invested  capital .  176,601.36 

Above  credit  and  under  20%  of  invested  capital .  261,902.04  30% 

Above  20%  of  invested  capital .  726,173.62  65% 


Tax 

S  78,570.61 
472,012.85 


Total  net  income  and  excess  profits  tax .  . $1,167,677.02 

Method  2. — War  Profits  Tax: 

Specific  exemption . $  3,000.00 

(a)  Average  prewar  income  plus  10%  of  increase  in  invested 
capital  since  prewar  period  ($111,242.84). 

^10%  of  Invested  capital  for  1918 .  220,751.70 

•omeln  excess  of  credit . .  943,925.32 


80 £ 


$550,583.46 


$755,140.25 


$1,167,677.02 

Total  Profits  Tax  (equals  the  War  Profits  Tax.  and  not  the  Excess  Profits  Tax, 

because  that  is  the  larger  figure) . $755,140.25 

Method  4. — Income  Tax: 

Specific  exemption . $  2,000.00 

Credit  for  profits  tax .  755,140.25 

Remainder  of  net  income .  410,536.77  12%  $  49,264.41 


Total  Income  and  Profits  Tax 


$1,167,677.02 


$804,404.66 


16 


THE  INCOME  AND  PROFITS  TAXES 


23.  Excess  Profits  Credit.  The  credit  for  the  Excess  Profits  Tax 
consists  of  a  specific  exemption  of  $3,000  plus  8%  of  the  invested  cap¬ 
ital,  the  determination  of  which  is  separately  discussed.  Only  the  net 
income  in  excess  of  this  credit  is  subject  to  the  Excess  Profits  Tax.  In 
all  cases  of  Return  covering  less  than  twelve  months,  the  credit  will  be 
proportionately  reduced. 

24.  War  Profits  Credit.  The  War  Profits  rate  applies  only  to  the  net 
income  which  exceeds  a  credit  consisting  of  a  specific  exemption  of 
$3,000  plus  the  prewar  profits,  adjusted  with  reference  to  changes  in  the 
invested  capital.  If  the  invested  capital  for  the  taxable  year  is  greater 
than  the  average  for  the  prewar  period,  the  credit  for  the  prewar  income 
is  increased  by  10%  of  the  additional  capital.  If  the  invested  capital 
has  been  reduced  since  the  prewar  period,  10%  of  the  difference  between 
the  invested  capital  for  the  current  year  and  the  average  for  the  pre¬ 
war  period  is  deducted  from  the  amount  of  the  prewar  income.  If  the 
prewar  income  as  so  adjusted  is  less  than  10%  of  the  average  invested 
capital  for  the  taxable  year,  the  credit  will  consist  of  the  sum  of 
$3,000  plus  10%  of  the  invested  capital.  A  corporation  which  accepts 
the  minimum  allowance  of  10%  need  not  report  as  to  the  prewar  condi¬ 
tions.  In  all  cases  of  Returns  covering  less  than  twelve  months  the 
credit  will  be  proportionately  reduced.  The  prewar  income  is  the  aver¬ 
age  net  income  for  the  calendar  years  1911,  1912,  and  1913,  but  includ¬ 
ing  only  as  many  of  such  years  during  the  whole  of  which  the  par¬ 
ticular  corporation  (or  its  predecessor  business)  was  in  existence.  Thus 
for  a  corporation  organized  in  February,  1912,  and  not  the  successor  to  a 
business  previously  in  existence,  the  prewar  period  is  the  calendar  year 
1913,  no  matter  how  much  income  may  have  been  earned  during  1912. 
The  net  income  shall  be  the  same  amount  as  that  reported  on  the  returns 
made  under  the  tax  laws  of  1909  and  1913,  except  that  the  federal  tax 
then  allowed  as  a  deduction  shall  be  added  and  dividends  not  exempt 
in  1913  must  be  deducted  for  that  year.  A  net  loss  for  anv  one  year  is 
not  included  in  finding  the  average,  which  is  based  only  upon  annual 
net  income.  Thus  if  a  corporation  had  a  net  income  of  $60,000  for 
1911,  a  net  loss  of  $10,000  for  1912  and  a  net  income  of  $10,000  for 
1913,  the  average  prewar  income  is  $35,000. 

25.  War  Profits  Credit  of  a  New  or  Reorganized  Business.  Where 

a  new  corporation  is  the  successor  to  a  business  previously  conducted  by 
an  individual,  partnership,  or  corporation,  in  case  of  a  reorganization, 
consolidation,  or  change  of  ownership,  the  income  and  invested  capital 
of  the  predecessor  business  for  the  prewar  period  shall  be  used  in  com¬ 
puting  the  War  Profits  Tax  of  the  new  corporation.  For  example,  a 
business  owned  for  many  years  by  Harvey  Elston  was  sold  in  1916  to 
a  new  corporation  in  which  Elston  had  no  interest.  The  new  corpora¬ 
tion  must  either  accept  the  minimum  allowance  of  10%  or  must  report 
the  net  income  and  invested  capital  of  Harvey  Elston  for  each  of  the 
years  1911,  1912,  and  1913,  in  order  to  determine  its  War  Profits  Credit. 
In  such  a  case,  the  net  income  of  the  prior  business  shall  be  ascertained 
as  nearly  as  possible  upon  the  same  basis  as  provided  for  corporations 
under  the  present  law,  with  a  reasonable  deduction  for  salary  or  com¬ 
pensation  to  the  individual  proprietor  or  members  of  the  partnership  for 


THE  INCOME  AND  PROFITS  TAXES 


17 


services  actually  rendered.  In  computing  the  invested  capital  in  such  a 
case  the  necessary  adjustments  may  be  made  to  establish  a  common 
basis  with  respect  to  assets  valued  differently  or  excluded  from  the 
invested  capital  before  the  reorganization.  A  new  corporation  which  is 
not  a  continuation  of  a  previous  business  and  which  was  not  in  existence 
luring  the  whole  of  at  least  one  calendar  year  during  the  prewar  period, 
that  is,  was  formed  after  January  1,  1913,  receives  a  War  Profits  Credit 
consisting  of  the  specific  exemption  of  $3,000  plus  a  “  constructive  ' ' 
prewar  income,  equal  to  the  same  percentage  of  its  invested  capital  for 
the  taxable  year,  but  not  less  than  10%,  as  the  average  percentage  of 
net  income  to  invested  capital  for  the  prewar  period  in  the  case  of  cor¬ 
porations  engaged  in  a  trade  or  business  of  the  same  general  class  as 
that  conducted  by  the  new  corporation.  If  this  average  percentage  has 
not  been  published  by  the  Commissioner  of  Internal  Revenue  at  least 
thirty  days  prior  to  the  time  when  the  Return  is  due,  then  the  Return 
shall  be  made  out  by  using  10%,  to  be  replaced  by  the  average  percent¬ 
age  when  determined.  If  at  any  time  during  the  taxable  year  a  majority 
of  the  stock  of  a  new  corporation  is  owned  or  controlled  directly  or 
indirectly  by  a  corporation  which  was  in  existence  during  the  whole 
of  at  least  one  calendar  year  during  the  prewar  period  or  if  50%  or 
more  of  the  gross  income  of  a  new  corporation  is  derived  from  Govern¬ 
ment  contracts  made  between  April  6,  1917,  and  November  11,  1918, 
then  these  provisions  shall  not  apply,  but  the  War  Profits  Credit  shall 
be  $3,000  plus  10%  of  the  invested  capital,  instead  of  the  average  per¬ 
centage. 

26.  Income  Tax  Credit.  Before  computing  the  Income  Tax,  credit 
is  allowed  for  the  amount  assessed  as  Profits  Tax  for  the  same  taxable 
year.  In  addition,  there  is  a  specific  exemption  for  a  domestic  corpora¬ 
tion  of  $2,000  and  the  net  income  is  also  reduced  by  the  amount  of  par¬ 
tially  exempt  interest  (such  as  that  upon  Liberty  Bonds),  which  is  sub¬ 
ject  to  the  Profits  Tax,  but  not  to  the  Income  Tax.  When  the  Return 
covers  less  than  twelve  months,  the  specific  exemption  is  proportionately 
reduced. 

27.  Profits  Tax  Fixed  by  Comparison.  The  chief  means  provided  by 
the  law  for  preventing  inequality  and  hardship  in  the  assessment  of 
the  Profits  Tax,  is  the  use  of  a  rate  found  by  comparison  with  repre¬ 
sentative  corporations  rather  than  the  rates  of  the  law  based  upon  the 
actual  invested  capital.  This  “comparative  rate, “  as  it  may  be  called, 
is  the  same  percentage  or  proportion  of  the  net  income  of  the  corpora¬ 
tion  in  question,  as  the  percentage  of  Profits  Tax  to  net  income  in  the 
case  of  representative  corporations  engaged  in  a  similar  business  whose 
invested  capital  can  be  satisfactorily  determined  and  which  are  similarly 
circumstanced  as  to  gross  income,  net  income,  profits  per  unit  on  business 
transacted  and  capital  employed,  amount  and  rate  of  war  profits  or  excess 
profits  and  all  other  relevent  facts.  For  example,  if  the  Profits  Tax  of 
representative  corporations  in  the  manufacturing  hardware  business  is 
17%  of  the  net  income,  in  the  case  of  any  manufacturing  hardware  busi¬ 
ness  where  any  of  the  following  conditions  exist,  the  Profits  Tax  will 
be  17%  of  the  net  income. 

28.  Application  of  the  Comparative  Rate.  The  Profits  Tax  will  be 
assessed  at  the  comparative  rate  in  the  following  cases:  (1)  Where  the 


18 


THE  INCOME  AND  PROFITS  TAXES 


Commissioner  is  unable  satisfactorily  to  determine  the  invested  capital. 
(2)  In  the  case  of  foreign  corporations.  (3)  Where  a  mixed  aggregate 
of  tangible  and  intangible  property  has  been  paid  in  for  stocks  and  bonds 
and  the  Commissioner  is  unable  to  determine  the  respective  values  of 
the  several  classes  of  property  at  the  time  of  payment  or  to  distinguish 
the  property  paid  in  for  stock  from  that  paid  in  for  bonds.  (4)  Where 
the  Commissioner  finds,  upon  application  of  the  corporation,  that  if  the 
tax  were  determined  by  the  general  rule  of  the  law  it  would,  owing  to 
abnormal  conditions  affecting  the  income  or  capital  of  the  corporation, 
work  upon  the  corporation  an  exceptional  hardship,  evidenced  by  gross 
disproportion  between  the  rate  of  the  tax  so  computed  and  the  rate  of  tax 
in  the  case  of  representative  corporations.  This  last  provision  shall  not 
apply  to  any  case  (a)  in  which  the  tax  is  high  merely  because  the  cor¬ 
poration  earned  during  the  year  a  high  rate  of  profits  upon  a  normal 
capital,  nor  (b)  in  which  the  50%  or  more  of  the  gross  income  was  de¬ 
rived  from  government  contracts  on  a  cost-plus  basis  or  made  between 
April  6,  1917,  and  November  11,  1918.  The  facts  calling  for  the  applica¬ 
tion  of  the  comparative  rate  should  be  set  forth  in  a  sworn  claim  filed  by 
the  taxpayer  with  the  Return  or  subsequently.  The  Return  must  show 
the  tax  as  computed  without  the  benefit  of  this  provision.  If  the  tax  so 
computed  is  less  than  50%  of  the  net  income,  the  first  installment,  pend¬ 
ing  the  decision  upon  the  claim,  shall  be  bas«d  upon  the  tax  so  computed. 
If  such  tax  is  50%  or  more  of  the  net  income,  the  installments  shall 
temporarily  be  based  upon  a  tax  equal  to  50%  of  the  net  income.  Adjust¬ 
ment  will  be  made  in  all  cases  after  the  tax  liability  has  finally  been 
determined,  and  if  it  exceeds  50%  of  the  net  income  the  excess  of  the 
correct  installments  over  the  amounts  actually  paid  shall  be  due  with 
interest  at  *£%  per  month. 

29.  Tax  for  Fiscal  Year  or  Part  of  Year.  Where  the  Return  of  a 
corporation  covers  a  fiscal  year,  the  invested  capital,  the  net  income, 
and  the  income  and  profits  tax  for  the  entire  fiscal  year  will  be  computed 
under  the  law  applicable  to  the  first  part  of  the  fiscal  year  and  again 
under  the  law  applicable  to  the  last  part  of  the  fiscal  year.  Each  tax 
will  then  be  divided  in  proportion  to  the  number  of  months  falling  in 
each  of  the  calendar  years.  Actual  earnings  during  the  particular  months 
may  not  be  considered.  Thus  a  corporation  which  has  made  a  Return 
covering  a  fiscal  year  ending  on  April  30,  1918,  must  file  an  amended 
Return  showing  the  invested  capital,  net  income,  and  tax  for  the  entire 
year  computed  under  the  new  law.  One  third  of  the  tax  shown  to  be 
due  by  the  amended  Return  will  be  assessed  for  the  first  four  months  of 
1918,  and  this  amount  will  be  credited  with  one-third  of  the  tax  shown 
to  be  due  by  the  original  Return  and  previously  paid.  Similarly,  when 
filing  the  Return  for  the  fiscal  year  ending  on  April  30,  1919,  the  tax 
must  be  computed  both  under  the  1918  and  1919  rates,  and  two-thirds 
of  the  first  amount  and  one-third  of  the  latter  amount  will  be  payable. 
Where  a  corporation  is  doing  business  for  only  part  of  the  taxable  year, 
where  the  basis  of  the  Return  changes  from  calendar  to  fiscal  year  or 
from  one  fiscal  year  to  another,  and  in  all  other  cases  where  a  Return 
covers  less  than  a  year,  the  credits  allowed  for  the  various  taxes  shall 
all  be  reduced  in  proportion  to  the  number  of  months  covered  by  the 


THE  INCOME  AND  PROFITS  TAXES 


19 


Return  (except  that  the  $2,000  specific  exemption  for  Income  Tax  need 
be  reduced  only  where  there  is  a  change  in  the  fiscal  period  on  which 
the  Return  is  based,  and  not  in  case  of  a  Return  for  a  portion  of  a  year 

for  some  other  cause). 

30.  Personal  Service  Corporations.  A  special  plan  of  taxation  is 
adopted  for  certain  corporations  in  which  services  rendered,  rather  than 
capita]  employed,  is  the  material  factor  in  producing  income.  Such  cor¬ 
porations  must  file  Returns  but  are  not  subject  to  either  the  Income 
Tax  or  the  Profits  Tax,  and  the  individual  stockholders  are  taxed  upon 
their  respective  shares  of  the  net  income,  whether  divided  or  not,  in  the 
same  manner  as  members  of  a  partnership.  Only  those  corporations  come 
within  these  provisions  whose  income  is  to  be  ascribed  primarily  to  the 
activities  of  the  principal  owners  or  stockholders  who  are  themselves 
regularly  engaged  in  the  active  conduct  of  the  business.  A  similar 
test  has  been  held  to  exclude  barber  shops  and  photograph  studios  unless 
the  principal  owners  were  actively  engaged  as  barbers  or  photographers. 
The  statute  further  excludes  corporations  where  capital  (whether  in¬ 
vested  or  borrowed)  is  a  material  income-producing  factor  or  where 
50%  or  more  of  the  gross  income  consists  of  profits  or  commissions  de¬ 
rived  from  (1)  trading  as  a  principal  or  (2)  from  government  contracts 
made  between  April  6,  1917,  and  November  11,  1918,  inclusive,  for  the 
benefit  of  the  United  States  wdth  any  department,  officer,  agency,  or 
contractor,  of  or  for  the  government.  Where  only  part  of  the  net  income 
of  a  corporation  is  derived  from  a  personal  service  business,  and  the 
other  part  from  a  business  requiring  invested  capital,  the  income  from 
the  personal  service  business  is  not  exempt.  But  where  not  less  than 
30%  of  the  net  income  is  derived  from  a  separate  business  or  distinctly 
separate  branch  of  the  business  which  is  a  personal  service  business, 
the  Profits  Tax  is  first  computed  on  the  portion  of  the  income  which 
is  derived  from  capital,  with  a  proportionate  reduction  of  the  Profits  Tax 
credits,  and  the  percentage  rate  of  such  tax  to  such  income,  if  not  less 
than  20%,  will  apply  to  the  income  from  the  personal  service  business.  If 
such  rate  is  less  than  20%,  the  Profits  Tax  upon  the  personal  service 
income  will  be  20%,  except  where  the  Profits  Tax,  computed  upon  the 
aggregate  income  and  capital  as  in  any  other  case  is  less  than  20%,  in 
which  event  that  method  shall  be  used.  The  corporation  Income  Tax 
applies  to  the  entire  net  income  where  any  portion  of  it  is  derived  from 
a  personal  service  business. 

31.  Incorporation  Retroactively  Effective.  Special  provision  is  made 
for  applying  the  corporation  taxes  to  the  income  of  a  business  owned  by 
an  individual  or  partnership  during  1918,  but  incorporated  before  July  1, 
1919.  This  section  applies  only  to  a  business  in  which  capital  is 
a  material  income-producing  factor  and  in  which  the  net  income 
for  1918  was  not  less  than  20%  of  the  invested  capital.  At  the  option 
of  the  individual  or  partnership  proprietor,  the  net  income  of  the  business 
from  January  1,  1918,  to  the  date  of  incorporation  will  be  subject  to  the 
Income  and  Profits  Tax  as  if  it  wras  the  net  income  of  a  corporation  and 
the  net  income  and  invested  capital  shall  be  computed  as  for  a  corpo¬ 
ration.  Such  income  will  not  then  be  subject  to  the  individual  income 
tax,  except  that  the  surtax  will  apply  to  any  profits  earned  after  Jan- 


10 


THE  INCOME  AND  PROFITS  TAXES 


uary  1,  1918,  when  drawn  out  or  distributed.  Where  this  section  is 
applied,  the  Capital  Stock  Tax  from  the  period  after  January  1,  1918, 
shall  also  be  paid. 

32.  Affiliated  Corporations  and  Consolidated  Returns,  Where  two 
or  more  corporations  are  affiliated  within  the  statutory  definition,  the 
Income  Tax  and  Profits  Tax  are  determined  on  the  basis  of  a  consoli¬ 
dated  Return.  In  this  return  all  the  corporations  are  treated  as  one  busi¬ 
ness  with  one  income  and  one  invested  capital,  which  is  entitled  to  only 
one  of  each  of  the  various  specific  credits.  In  computing  income  and 
capital,  all  intercompany  accounts  and  investments  in  subsidiaries  are 
eliminated.  The  tax  is  assessed  against  the  various  companies  in  such 
proportion  as  may  be  agreed  upon  among  them,  or  in  proportion  to  the 
respective  net  income  where  there  is  no  agreement.  The  consolidated 
Return  is  required  (1)  where  one  corporation  owns  or  controls  sub¬ 
stantially  all  of  the  stock  of  the  other  or  others  and  (2)  where  sub¬ 
stantially  all  of  the  stock  of  the  affiliated  corporations  is  owned  or 
controlled  by  the  same  interests.  In  a  similar  connection  the  Depart¬ 
ment  has  held  that  “substantially  all  of  the  stock’ ’  means  95%  or 
more.  No  consolidated  Return  shall  include  the  net  income  or  invested 
capital  of  a  corporation  which  was  organized  after  August  1,  1914,  and 
was  not  the  successor  to  a  then  existing  business  and  which  derived 
50%  or  more  of  its  gross  income  from  government  contracts  made 
between  April  6,  1917,  and  November  11,  1918. 

33.  Exempt  Corporations.  The  following  corporations  and  organiza¬ 
tions  are  exempt  from  the  Income  Tax,  and  also  from  the  Profits  Tax: 
(1)  labor,  agricultural,  or  horticultural  organizations;  (2)  mutual  savings 
banks  not  having  a  capital  stock  represented  by  shares;  (3)  fraternal 
beneficiary  societies,  orders,  or  associations,  (a)  operating  under  the 
lodge  system  or  for  the  exclusive  benefit  of  the  members  of  a  fraternity 
itself  operating  under  the  lodge  system,  and  (b)  providing  for  the  pay¬ 
ment  of  life,  sick,  accident,  or  other  benefits  to  the  members  of  such 
society,  order,  or  association  or  their  dependents;  (4)  domestic  building 
and  loan  associations  and  co-operative  banks  without  capital  stock  organ¬ 
ized  and  operated  for  mutual  purposes  and  without  profit;  (5)  cemeterv 
companies  owned  and  operated  exclusively  for  the  benefit  of  their  mem¬ 
bers;  (6)  corporations  organized  and  operated  exclusively  for  religious, 
charitable,  scientific,  or  educational  purposes,  or  for  the  prevention  of 
cruelty  to  children  or  animals,  no  part  of  the  net  earnings  of  which 
inures  to  the  benefit  of  any  private  stockholder  or  individual;  (7) 
business  leagues,  chambers  of  commerce,  or  boards  of  trade,  not  organ¬ 
ized  for  profit  and  no  part  of  the  net  earnings  of  which  inures  to 
the  benefit  of  any  private  stockholder  or  individual;  (8)  civic 
leagues  or  organizations  not  organized  for  profit  but  operated  exclusively 
for  the  promotion  of  social  welfare;  (9)  clubs  organized  and  operated 
exclusively  for  pleasure,  recreation,  and  other  non-profitable  purposes, 
no  part  of  the  net  earning  of  which  inures  to  the  benefit  of  any  private 
stockholder  or  member;  (10)  farmers’  or  other  mutual  hail,  cyclone,  or 
fire  insurance  companies,  mutual  ditch  or  irrigation  companies,  mutual 
or  co-operative  telephone  companies,  or  like  organizations  of  a  purely 
local  character,  the  income  of  which  consists  solely  of  assessments,  dues, 


THE  INCOME  AND  PROFITS  TAXES 


21 


and  fees  collected  from  members  for  the  sole  purpose  of  meeting  expenses; 

(11)  farmers’,  fruit  growers’,  or  like  associations,  organized  and  operated 
as  sales  agents  for  the  purpose  of  marketing  the  products  of  members 
and  turning  back  to  them  the  proceeds  of  sales,  less  the  necessary  selling 
expenses,  on  the  basis  of  the  quantity  of  produce  furnished  by  them; 

(12)  corporations  organized  for  the  exclusive  purpose  of  holding  title 
to  property,  collecting  income  therefrom,  and  turning  over  the  entire 
amount  thereof,  less  expenses,  to  an  organization  which  itself  is  exempt 
from  the  tax  imposed  by  this  title;  (13)  federal  land  banks  and  national 
farm-loan  associations;  (14)  personal  service  corporations. 

34.  Exemption  Conditional.  A  corporation  which  is  exempt  by  the 
above  provisions  only  if  no  part  of  the  net  earnings  inures  to  the  ben¬ 
efit  of  any  private  stockholder  or  upon  any  similar  condition,  must 
establish  its  right  to  be  exempt  by  filing  with  the  collector  of  internal 
revenue  affidavits  showing  the  purpose  and  nature  of  the  organization, 
the  source  of  its  income,  the  disposition  of  the  same,  and  other  infor¬ 
mation  to  establish  the  required  condition.  Thereafter,  no  Return  is 
required. 

35.  Particular  Corporations  Not  Exempt.  If  a  corporation  does  not 
come  within  one  of  the  classes  described,  it  is  not  exempt  merely  because 
it  is  organized  not  for  profit.  A  corporation  formed  as  a  family  affair 
to  hold  property  together  is  not  exempt.  Subsidiary  corporations  are 
regarded  as  distinct  entities,  and  are  not  exempt  because  they  are  owned 
by  a  holding  corporation  which  pays  income  tax  when  it  receives  the 
earnings  of  the  subsidiary.  Nor  is  a  corporation  exempt  because  it  is 
owned  by  and  is  a  subsidiary  of  a  corporation  within  one  of  the  exempted 
classes.  The  exemption  for  “agricultural  or  horticultural  organizations” 
does  not  include  a  corporation  engaged  for  profit  in  agricultural  pur¬ 
suits,  such  as  the  ownership  and  operation  of  sugar  plantations.  Cemetery 
companies  are  not  exempt  if  operated  for  profit.  Mutual  insurance  com¬ 
panies  receiving  income  other  than  assessments  or  dues  for  the  sole 
purpose  of  meeting  expenses  are  taxed  upon  such  income.  Co-operative 
stores  or  merchandising  organizations  are  not  exempt. 

36.  Returns  Required.  Every  corporation  not  entirely  exempt  (under 
par.  33)  and  every  personal  service  corporation  must  file  an  annual 
Return  (on  Form  1031)  showing  in  detail  its  gross  and  net  income  for 
the  calendar  or  fiscal  year.  This  is  required  even  though  the  corporation 
is  not  subject  to  tax,  as  where  its  net  income  is  less  than  the  exemption 
and  credits.  If  the  net  income  is  $3,000  or  more,  a  Return  for  the 
Profits  Tax  (Form  1103)  is  also  required.  The  Returns  must  be  sworn 
to  by  the  president  or  principal  executive  officer  and  also  by  the  treasurer 
or  principal  financial  officer,  and  must  be  filed  on  or  before  March  15 
of  each  year,  or  if  they  cover  a  fiscal  year,  on  or  before  the  fifteenth 
day  of  the  third  month  following  the  end  of  such  fiscal  year.  They 
are  filed  with  the  collector  of  internal  revenue  for  the  district  in  which 
is  located  the  principal  office  of  the  corporation,  where  are  kept  its 
books  of  account  and  other  data  from  which  the  Return  is  prepared. 
(For  a  further  discussion  of  the  Return,  see  pars.  183-188). 


22 


THE  INCOME  AND  PROFITS  TAXES 


37.  Foreign  Corporation.  A  corporation  organized  under  the  laws  of 
a  foreign  country,  even  though  it  has  offices  or  plants  in  the  United 
States,  is  taxed  only  upon  the  net  income  received  from  sources  in  this 
country.  Domestic  corporations  are  taxed  upon  their  entire  income  from 
all  sources,  even  though  they  may  have  most  of  their  capital  invested 
in  other  countries  and  may  receive  most  of  their  income  from  abroad. 
A  foreign  corporation  may  deduct  from  its  gross  income  received  from 
sources  in  this  country  the  general  deductions  allowed  by  the  statute,  to 
the  extent  that  they  are  connected  with  the  taxable  income.  A  foreign 
corporation  is  not  allowed  the  $2,000  exemption  from  Income  Tax  nor 
the  $3,000  exemption  from  Profits  Tax.  If  a  foreign  corporation  is  not 
engaged  in  trade  or  business  in  this  country  and  has  no  office  or  place 
of  business  here,  a  tax  of  10%  must  be  withheld  and  paid  on  its  behalf 
by  the  person  in  this  country  who  makes  the  payment  of  any  fixed  or 
determinable  annual  or  periodical  income  (except  interest  on  tax  free 
bonds  and  dividends)  to  such  foreign  corporation.  The  corporation  itself 
then  pays  the  balance  of  the  tax. 

3.  Estates  and  Fiduciaries. 

38.  Estates  Taxed  as  Entities.  Whenever  an  estate  receives  any 
income  which  is  not  received  for  distribution  to  known  beneficiaries,  it 
is  taxed  upon  such  income  as  if  it  were  an  individual.  The  Return 
(Form  1040)  must  be  filed  and  the  net  income  is  determined  in  the  same 
way.  It  is  subject  to  the  normal  tax  and  the  surtax,  and  the  same  cred¬ 
its  are  allowed,  including  the  personal  exemption  of  $1,000.  This  applies 
to:  (1)  Estates  of  deceased  persons  receiving  income  during  the  period 
of  administration  or  settlement  of  the  estate;  (2)  Income  accumulated 
in  trust  (a)  for  the  benefit  of  unborn  or  unascertained  persons,  or  per¬ 
sons  with  contingent  interests  and  (b)  for  future  distribution  to  bene¬ 
ficiaries  known  or  unknown.  It  does  not  apply  to  income  collected  by  a 
guardian,  to  be  distributed  as  directed  by  the  court.  Profits  realized 
by  a  sale  of  property  of  the  estate  is  to  be  included.  The  income  upon 
which  the  estate  has  been  taxed  becomes  a  part  of  the  estate  and  is 
not  subject  to  any  further  income  tax  when  it  is  subsequently  distributed. 

39.  Returns  of  Fiduciaries.  Where  the  income  of  an  estate  is  to  be 
distributed  periodically,  whether  at  regular  intervals,  at  the  convenience 
of  the  fiduciary,  at  the  request  of  the  beneficiary,  or  at  periods  deter¬ 
mined  in  any  other  way  and  not  amounting  to  an  accumulation,  the 
income  is  not  taxed  to  "the  estate  but  only  to  the  beneficiary,  whose 
individual  Return  must  show  his  share  in  such  income  whether  distributed 
and  paid  to  him  or  not.  The  fiduciary  must,  however,  make  an  annual 
Return  (Form  1041)  showing  the  net  income  of  the  estate,  computed  the 
same  as  for  an  individual,  and  the  share  of  every  beneficiary  therein, 
whether  distributed  or  not,  in  every  case  where  the  net  income  of  the 
estate  is  $1,000  or  over,  or  where  any  beneficiary  has  a  net  income 
of  $1,000  or  over,  or  $2,000  if  married,  or  is  a  non-resident  alien. 
The  term  li  fiduciary”  includes  a  guardian,  trustee,  executor,  adminis¬ 
trator,  receiver,  conservator,  or  any  person  holding  in  trust  in  a.  similar 
capacity  an  estate  in  which  another  person  has  the  beneficial  interest. 


THE  INCOME  AND  PROFITS  TAXES 


23 


It  does  not  include  a  person  acting  under  a  power  of  attorney  although 
in  full  control  of  the  property  of  his  principal,  nor  a  receiver  in  possession 
of  only  part  of  the  property  of  an  individual.  Any  one  of  joint  fiduciaries 
may  execute  the  Return.  Where  there  is  one  trustee  acting  in  various 
trusts  created  by  the  same  person,  one  Return  should  be  filed,  although 
the  trusts  may  have  been  created  by  different  instruments  and  have 
different  beneficiaries.  This  does  not  apply  to  separate  trust  estates 
which  are  subject  to  taxation  as  entities.  Where  a  trustee  acts  in  various 
trusts  for  the  same  beneficiaries,  but  created  by  different  persons,  sep¬ 
arate  Returns  must  be  filed  for  each  estate. 

40.  Fiduciaries  as  Agents.  A  fiduciary  acting  for  a  minor  or  an 
incompetent  person  is  required  to  file  the  individual  Return  (Form  1040) 
of  such  person,  as  his  agent,  which  is  in  addition  to  the  Return  (Form 
1041)  required  of  the  fiduciary.  An  executor  or  administrator  must  file 
the  individual  Return  (Form  1040)  of  a  person  dying  within  the  year 
who  received  during  the  year  a  net  income  of  $1,000  or  over  if  single, 
or  $2,000  or  over  if  married.  This  is  in  addition  to  the  Return  (also 
on  Form  1040)  required  of  the  fiduciary  to  showT  the  income  received 
by  the  estate  subsequent  to  the  death  and  before  the  end  of  the  year. 
A  receiver,  assignee,  trustee  in  bankruptcy,  or  other  fiduciary,  if  operat¬ 
ing  the  property  or  business  of  a  corporation,  must  make  a  Return  for 
the  corporation  (Form  1031)  and  pay  the  tax  on  its  behalf. 

4.  Partnerships. 

41.  Must  File  Returns.  Although  a  partnership  itself  is  not  taxed 
on  its  income,  the  law  requires  every  partnership  to  file  a  Return  (Form 
1065)  showing  its  gross  income  and  net  income,  -which  is  determined 
according  to  the  requirements  of  the  Income  Tax  Law.  Apparently  the 
Return  must  be  filed  even  though  the  firm  has  no  net  income  for  the  year. 
Any  one  of  the  partners  may  sign  and  swear  to  the  Return,  which  is  sub¬ 
ject  to  the  general  requirements  for  Returns  (stated  at  pars.  183-188), 
and  may  cover  the  calendar  year  or  a  fiscal  year  as  in  the  case  of  indi¬ 
viduals  and  corporations.  The  Return  must  show  the  name  and  address 
of  each  partner  and  his  share  in  the  net  income  of  the  firm.  This  amount 
must  be  included  in  the  taxable  income  of  the  partner,  as  shown  on 
his  individual  Return,  without  reference  to  the  amounts  actually  received 
by  him  as  distributions  of  the  firm’s  earnings.  A  partnership  which  is 
reorganized  by  incorporating  after  January  1,  1918,  and  before  July  1, 
1919,  may  at  its  option  be  taxed  as  a  corporation  after  January  1,  1918, 
paying  the  Income  Tax,  Profits  Tax,  and  Capital  Stock  Tax  (read  par.  31). 

PART  2.  DETERMINATION  OF  INVESTED  CAPITAL. 

42.  Distinguished  from  Capital  Stock  or  Capital  Employed.  The  in¬ 
vested  capital  which  is  used  in  computing  the  Profits  Tax  must  be 
determined  in  accordance  with  the  statutory  provisions  and  may  be 
an  amount  entirely  different  from  the  “capital”  as  determined  for  other 
purposes  and  by  other  standards.  Two  general  rules  underlie  the  require¬ 
ments  as  to  invested  capital:  (1)  It  consists  of  the  amount  invested  by 


24 


THE  INCOME  AND  PROFITS  TAXES 


the  owners  at  the  time  the  business  wras  organized  or  subsequently, 
valued  as  of  the  time  of  investment  rather  than  as  of  the  present  time; 
(2)  property  of  certain  kinds  invested  in  the  business  may  be  included 
in  the  invested  capital  only  to  a  limited  extent.  In  addition,  the  in¬ 
vested  capital  must  be  reduced  where  part  of  it  is  invested  during  the 
taxable  year  in  property  which  produces  a  tax-exempt  income.  The  in¬ 
vested  capital  should  be  determined  by  carefully  following  the  direc¬ 
tions  on  the  Return,  which  indicate  in  general  the  following  method  of 
procedure. 

43.  Paid  Up  Capital  Stock.  While  the  invested  capital  is  not  in 
all  cases  represented  by  the  paid  up  capital  stock,  this  is  the  starting 
point  for  its  determination.  Shares  issued  upon  unpaid  subscription 
or  otherwise  entirely  wdthout  consideration  cannot,  of  course,  represent 
invested  capital.  Where  stock  subscriptions  are  paid  in  good  faith 
with  enforceable  notes  bearing  a  reasonable  interest,  the  notes  may 
be  considered  as  tangible  property  paid  in  for  the  stock,  but  if  there 
is  any  agreement  or  understanding  that  the  notes  shall  be  paid  only  out 
of  the  profits  of  the  company,  or  if  the  interest  or  principal  is  not  paid 
within  a  reasonable  time,  the  notes  will  be  held  merely  colorable  and 
will  be  excluded.  Where'  stock  subscriptions  or  notes  are  actually  paid 
by  crediting  profits  or  dividends,  this  is  equivalent  to  the  payment  of 
cash,  which  is  included  in  invested  capital  from  the  date  of  payment. 
Even  though  all  of  the  outstanding  capital  stock  has  been  fully  paid  for, 
the  time  and  method  of  payment  must  nevertheless  be  analyzed,  for 
such  adjustment  as  may  be  necessary  to  comply  with  the  statutory 
restrictions. 

44.  Paid-In  Surplus  and  Undivided  Profits.  To  the  paid-in  capital 
of  the  company  is  added  the  paid-in  or  earned  surplus  as  of  the  first 
day  of  the  taxable  year.  The  earnings  so  included  must  first  be  reduced 
by  the  amount  of  any  net  loss  or  accumulated  deficit,  but  the  capital 
originally  paid  in  need  not  be  reduced  on  this  account.  Profits  earned 
during  the  taxable  year,  even  though  remaining  in  the  business,  may 
not  be  included  in  the  invested  capital,  but  if  such  profits  are  dis¬ 
tributed  in  cash  which  is  then  reinvested,  the  invested  capital  is 
apparently  increased.  Paid-in  surplus  must  be  analyzed  in  the  same 
way  as  paid-in  capital  stock,  and  earned  surplus  or  undivided  profits 
must  be  analyzed  to  establish  that  it  is  not  merely  a  book  surplus  but 
an  actual  addition  to  the  investment  of  the  owners.  To  this  end,  the 
accounts  of  the  company  back  to  the  date  of  its  organization  are  subject 
to  examination,  in  order  to  determine  that  depreciation  allowances  have 
at  all  times  been  adequate  to  represent  the  actual  reduction  of  profits 
on  this  account,  that  obsolescence  has  been  properly  recognized,  that 
discarded  property  has  been  charged  against  the  profits,  and  that  no 
amount  has  been  added  by  marking  up  property  or  revaluing  assets, 
and  that  in  all  other  respects  the  surplus  represents  actual  earnings. 
On  the  other  hand,  adjustment  of  the  surplus  in  favor  of  the  taxpayer 
will  be  made  where  the  book  surplus  has  been  reduced  by  marking  dowm 
assets  which  have  not  actually  depreciated  or  disappeared. 

45.  Borrowed  Capital.  The  definition  of  invested  capital  expressly 
excludes  borrowed  capital.  Where  a  business  is  actually  conducted  upon 


THE  INCOME  AND  PROFITS  TAXES 


25 


borrowed  money  or  upon  the  strength  of  its  credit,  its  invested  capital 
is  not  thereby  increased,  although  this  may  serve  as  the  reason  for 
assessing  the  tax  at  the  comparative  rate  explained  above.  Even 
though  money  is  loaned  to  a  corporation  by  its  shareholders, 
it  does  not  become  invested  capital  if  it  remains  a  debt,  payable  with 
the  other  debts  of  the  corporation  in  priority  to  the  capital  liability 
of  the  company.  Where  money  is  advanced  by  stockholders  under  an 
agreement  that  their  claim  shall  be  postponed  to  all  other  creditors 
but  shall  come  before  the  other  stockholders,  an  interest  somewhat  like 
that  of  a  preferred  stockholder  is  created  and,  possibly,  such  amounts 
may  be  regarded  as  invested  capital.  They  are,  however,  in  form  bor¬ 
rowed  capital  and  the  general  rule  is  that  the  capital  of  a  corporation 
must  be  represented  by  its  legally  issued  shares  of  stock,  and  must 
belong  to  the  holders  of  its  shares  in  proportion  to  the  stock  held 
by  them. 

46.  Paid-In  Cash  as  Capital.  The  invested  capital  of  a  corporation 
includes  without  limit  the  amount  of  cash  paid  in  for  its  stock  or  shares 
or  paid  in  to  become  the  surplus  of  the  corporation.  The  amount  so 
paid  in  may  be  more  or  less  than  the  book  capital,  which  must  then 
be  adjusted  accordingly.  The  capital  originally  paid  in  need  not  be 
reduced  on  account  of  any  net  loss,  accumulated  deficit,  or  other  impair¬ 
ment  of  capital  not  resulting  in  a  return  to  the  stockholders. 

47.  Good  Will  and  Intangible  Property  as  Capital.  The  invested  cap¬ 
ital  may  include  only  a  limited  amount  of  intangible  property  paid  in 
as  the  consideration  for  the  issues  of  stock  or  shares.  Where  such 
property  "was  purchased  for  cash  or  its  equivalent,  no  limit  applies. 
Good  will  and  similar  property  developed  in  the  business  may  not  be 
included  in  the  invested  capital,  but  it  is  necessary  that  it  be  specifically 
purchased  or  paid  in.  As  used  in  this  connection,  intangible  property 
means  good  will,  trade  marks,  brands,  patents,  copyrights,  processes, 
franchises,  and  other  like  property,  but  does  not  include  stocks,  bonds, 
notes,  leaseholds,  insurance  policies,  and  other  property  commonly  de¬ 
scribed  as  intangible  property  but  defined  as  tangible  property  by  the 
Profits  Tax  Law.  Where  stock  wms  issued  for  such  intangible  property, 
the  amount  included  in  the  invested  capital  must  not  exceed  any  one 
of  the  following  maximums  and  the  excess,  if  any,  must  be  deducted 
from  the  capital  and  surplus:  (1)  as  to  each  item  or  parcel  of  such 
property,  the  lower  of  either  (a)  the  actual  cash  value  of  the  prop¬ 
erty  at  the  time  paid  in  or  (b)  the  par  value  of  the  stock  or  shares 
issued  in  payment  for  the  property,  which  in  the  case  of  stock  or  shares 
issued  at  a  nominal  value  or  having  no  par  value,  shall  be  the  fair  mar¬ 
ket  value  of  the  stock  as  of  that  date;  (2)  the  aggregate  of  all  such 
property  paid  in  prior  to  March  3,  1917,  may  not  exceed  25%  of  the 
par  value  of  the  total  outstanding  stock  on  that  date;  (3)  the  aggregate 
of  all  such  property  paid  in  before  or  after  March  3,  1917,  may  not 
exceed  25%  of  the  par  value  of  the  total  outstanding  sfhck  at  the 
beginning  of  the  taxable  year. 

48.  Tangible  Property  as  Capital.  Tangible  property,  which  includes 
all  property  other  than  that  defined  by  the  law  as  intangible  property, 
may  be  included  in  the  invested  capital  to  the  full  amount  of  its  actual 


26 


THE  INCOME  AND  PROFITS  TAXES 


value  at  the  time  paid  in  for  stock  or  shares.  Where  the  taxpayer 
satisfactorily  shows  that  the  actual  cash  value  at  that  time  was  clearly 
and  substantially  in  excess  of  the  par  value  of  the  stock  or  shares 
specifically  issued  for  such  property,  the  excess  may  be  treated  as  paid-in 
surplus  to  be  added  to  the  book  capital  and  surplus.  The  fact  that 
property  may  have  substantially  increased  in  value  after  having  been 
paid  into  the  corporation  is  not  material,  as  any  increase  in  the  value 
of  the  property  of  the  corporation  does  not  add  to  its  invested  capital 
until  realized  by  sale  or  disposition  of  the  property;  only  in  this  way 
does  it  become  a  part  of  the  undivided  profits  or  surplus.  To  illustrate: — 
If  a  coal  mine,  of  the  proved  value  of  $250,000  in  1903  and  $500,000  in 
1917,  was  conveyed  to  a  corporation  in  1903  as  payment  for  its  entire 
stock  of  the  par  value  of  $100,000,  the  invested  capital  of  the  corpo¬ 
ration  will  be  increased  to  $250,000  upon  a  claim  for  $150,000  as  paid 
in  surplus,  but  will  not  include  the  addition  in  value  occurring  in  later 
years.  A  similar  addition  to  paid  in  surplus  with  respect  to  property 
purchased  by  the  corporation  for  cash  rather  than  taken  for  stock  has 
been  allowed  by  the  Regulations  issued  under  the  1917  law,  and  apparently 
is  not  inconsistent  with  the  new  law. 

49.  “Mixed  Aggregate”  of  Good  Will  and  Other  Property.  Where  a 
corporation  is  formed  to  take  over  a  going  business,  it  may  acquire 
a  mixed  aggregate  of  tangible  assets  and  intangible  assets,  including 
the  good  will  of  the  former  business.  If  such  a  mixed  aggregate  was 
purchased  with  cash,  the  invested  capital  is  not  affected,  since  the  cash 
paid  in  remains  the  invested  capital.  But  where  such  a  mixed  aggregate 
has  been  purchased  with  stock  of  the  new  corporation,  no  matter  how 
many  years  ago,  it  is  necessary  to  ascertain  how  much  of  such  stock  was 
issued  for  the  tangible  property  and  how  much  of  such  stock  wras  issued 
for  the  intangible  property,  since  the  latter  may  not  exceed  the  stat¬ 
utory  limit.  Any  evidence  which  the  taxpayer  can  submit  to  show  this 
fact  will  be  received  by  the  Treasury  Department.  When  the  taxpayer 
satisfactorily  proves  the  actual  cash  value  of  the  tangible  property  at 
the  time  of  the  purchase,  it  will  be  assumed  that  stock  in  that  amount 
of  par  value  was  issued  for  the  tangible  property  and  that  all  the 
remaining  stock  was  issued  for  the  good  will,  but  unless  the  taxpayer 
satisfactorily  proves  the  value  of  the  tangible  property,  the  presumption 
will  be  that  all  of  the  stock  was  issued  for  the  good  will  and  intangible 
property,  and  the  invested  capital  will  be  reduced  accordingly.  Where 
the  Commissioner  is  unable  to  satisfactorily  determine  the  respective 
amounts  of  stock  issued  for  the  different  classes  of  property,  the  tax 
will  be  assessed  by  comparison  with  similar  corporations.  This  para¬ 
graph  applies  to  the  case  of  a  business  reorganized  after  March  3,  1917, 
only  in  connection  with  the  special  provisions  applicable  to  such  reor¬ 
ganization,  which  are  discussed  in  a  subsequent  paragraph. 

50.  Appreciation  and  Depreciation.  As  has  been  stated,  property 
paid  in  as  capital  is  valued  at  the  time  it  is  paid  in.  Therefore  the 
invested  capital  cannot  be  increased  by  the  appreciation  in  the  value 
of  property,  even  though  established  by  expert  appraisal  or  indisputable 
evidence  of  value.  If  property  has  at  any  time  been  marked  up  on  the 
books  because  of  such  increase  in  value,  the  capital  and  surplus  as  shown 


THE  INCOME  AND  PROFITS  TAXES 


07 
£  I 


by  the  books  must  be  reduced  to  eliminate  such  appreciation.  On  the 
other  hand,  if  property  has  decreased  in  value  because  of  physical 
exhaustion  or  obsolescence,  the  Regulations  require  recognition  of  such 
diminished  value  in  connection  with  determining  the  surplus.  In  other 
words,  the  surplus  shown  by  the  books  does  not  in  fact  represent  the 
accumulated  gain  unless  it  has  been  charged  with  the  loss  actually 
accrued  by  reason  of  the  diminishing  value  of  property,  and  with  all 
other  losses.  However,  if  there  is  no  surplus,  such  losses  need  not  be 
applied  against  the  paid-in  capital  or  the  paid-in  surplus,  for  which  full 
credit  is  given,  although  the  amounts  may  to  some  extent  have  disap¬ 
peared  from  the  assets  of  the  company  because  of  losses. 

51.  Changes  in  Capital  During  the  Year.  The  invested  capital  used 
in  this  connection  is  the  average  invested  capital  for  the  taxable  year 
or  for  the  prewar  period.  Therefore,  after  having  made  the  necessary 
adjustments  in  the  capital  as  of  the  first  day  of  the  taxable  year,  it 
is  necessary  to  show  the  changes  subsequently  occurring.  The  average 
for  the  prewar  period  is  found  after  each  year  has  been  separately  treated, 
following  all  requirements  applying  to  the  taxable  year.  As  already 
stated,  nothing  can  be  added  on  account  of  any  addition  made  to  the 
surplus  or  undivided  profits  from  profits  earned  during  the  year  in 
question.  If  new  stock  is  issued  for  cash  or  property,  this  amount  should 
be  shown  as  an  addition  to  the  invested  capital.  If  any  stock  is  retired, 
the  invested  capital  must  be  correspondingly  reduced.  If  the  federal 
income  tax  for  1917,  paid  in  July,  1918,  exceeded  the  1918  profits  earned 
to  that  date,  the  surplus  must  be  reduced  on  this  account.  All  changes 
must  be  computed  as  an  average  for  the  year;  in  other  words,  if  new 
capital  is  paid  in  on  April  1,  and  is  in  the  business  for  only  three  quar¬ 
ters  of  the  year,  the  invested  capital  is  not  increased  by  the  full  amount, 
but  only  by  three-quarters  of  it.  New  capital  of  $50,000  paid  in  on 
January  15  increases  the  invested  capital  by  $50,000  for  liy2  months 
or  $47,916.67  for  12  months. 

52.  Reduction  of  Invested  Capital  by  Dividends.  Dividends  paid 
must  be  deducted  from  the  invested  capital  where  paid  from  the  surplus 
or  undivided  profits  on  hand  at  the  beginning  of  the  year,  and  dividends 
paid  during  the  first  sixty  days  of  the  year  are  deemed  to  have  been 
paid  from  such  previously  accumulated  profits.  Dividends  subsequently 
paid  are  deemed  to  distribute  the  current  profits,  to  the  extent  that 
they  are  sufficient.  The  profits  earned  after  the  beginning  of  the  taxable 
year  and  before  the  date  of  payment  of  the  dividend  should  be  ascer¬ 
tained,  and  if  such  profits  are  sufficient  to  cover  the  dividend,  no  reduc¬ 
tion  of  the  invested  capital  should  be  made.  If  the  books  of  the  corpo¬ 
ration  do  not  show  the  profits  earned  up  to  the  date  of  payment  of  the 
dividend,  the  earnings  shown  by  the  books  for  any  accounting  period 
in  which  the  dividend  was  paid  must  be  divided  ratably  over  the  period. 
For  example,  suppose  that  a  corporation  paid  a  dividend  of  $10,000  on 
February  15  and  another  of  $40,000  on  April  15,  1919.  Suppose,  also, 
that  its  books  did  not  show  the  amount  of  profits  earned  between  Jan¬ 
uary  1,  1919,  and  April  15,  1919,  but  did  show  that  $60,000  was  earned 
between  January  1  and  June  30,  1919.  In  this  case,  it  will  be  held 
that  seven-twelfths  or  $35,000  of  the  $60,000  w^as  earned  before  April  15 


28 


THE  INCOME  AND  PROFITS  TAXES 


and  that  all  of  the  first  dividend  and  $5,000  of  the  second  dividend  was 
paid  from  the  previously  accumulated  surplus.  The  invested  capital  must 
therefore  be  reduced  by  deducting  $10,000  for  10%  months,  or  $8,750, 
and  $5,000  for  8%  months,  or  $3,541.67,  a  total  deduction  of  $12,291.66. 
This  result  apparently  will  not  be  affected  by  any  showing  short  of 
a  book  profit,  even  though  the  volume  of  sales  or  other  facts  may 
indicate  that  the  whole  $60,000  was  earned  before  February  15  and  that 
the  business  after  that  date  was  unprofitable.  Probably  the  same  rule 
will  apply  to  determine  the  current  profits  up  to  a  given  date  in  con¬ 
nection  with  other  payments. 

53.  Inadmissible  Assets.  The  invested  capital  must  be  reduced  to  the 
extent  that  any  part  of  it  is  invested  during  the  taxable  year  in  assets 
(other  than  obligations  of  the  United  States)  which  produce  an  income 
which  is  exempt  from  the  tax.  Such  inadmissible  assets  consist  of 
stocks  in  domestic  corporations,  securities  issued  under  the  Federal  Farm 
Loan  Act,  State  and  Municipal  bonds,  and  similar  tax  exempt  securities, 
but  do  not  include  any  bonds  of  the  United  States  Government  nor  any 
tax-free  covenant  bonds.  Where  such  exempt  securities  are  carried  with 
borrowed  money,  the  interest  upon  which  may  not  be  deducted  from 
the  gross  income  because  of  the  limitation  discussed  in  par.  157,  there 
may  be  excluded  from  the  inadmissible  assets  the  same  proportion  of  the 
total  investment  as  the  disallowed  interest  bears  to  the  exempt  income, 
since  the  income  is  thus  in  effect  included  in  the  taxable  net  income. 
Similarly,  where  the  taxable  net  income  includes  gains  or  profits  derived 
from  selling  or  otherwise  dealing  in  such  securities,  the  investment  in 
inadmissible  assets  may  be  reduced  to  the  same  proportion  of  the  actual 
investment  which  the  exempt  income  derived  from  such  assets  during  the 
taxable  year  bears  to  the  entire  net  income  derived  therefrom,  including 
the  exempt  income  and  the  taxable  profits.  To  illustrate:  The  Hawley 
Chair  Company  buys  two  bonds  of  the  Morse  County  Drainage  District 
for  $1,800,  carying  them  in  part  with  a  loan  of  $1,000  at  7%.  It  holds 
the  bonds  for  six  months;  during  this  time  it  receives  an  interest  pay¬ 
ment  of  $60  and  pays  $35  interest  on  the  loan;  it  then  sells  them  at  a 
profit  of  $125.  In  this  case  the  exempt  interest  is  in  fact  only  $25,  five- 
twelfths  of  the  total  interest,  representing  an  investment  of  $750.  As 
the  exempt  income  is  only  one-sixth  of  the  total  income,  including  the 
$125  profit,  only  one-sixth  of  $750,  or  $125,  is  deemed  invested  in  inadmis¬ 
sible  assets. 

54.  The  Deduction  for  Inadmissible  Assets.  After  the  amount  of  the 
investment  in  inadmissible  assets  has  been  determined  in  the  manner 
stated,  it  must  be  reduced  to  the  basis  of  an  average  for  the  year,  by 
the  same  method  used  for  changes  in  the  invested  capital.  The  average 
amount  of  total  assets,  admissible  and  inadmissible,  held  during  the 
taxable  year,  also  must  be  thus  ascertained.  The  average  invested  cap¬ 
ital  must  then  be  reduced  by  the  percentage  found  for  the  average  inad¬ 
missible  assets  as  compared  with  the  average  total  assets.  To  illustrate 
by  the  case  of  the  Hawley  Chair  Company  above:  The  inadmissible  assets 
amount  to  $125  for  six  months,  or  $62.50  for  the  year.  Assuming  that 
the  average  total  assets  of  the  company,  not  the  net  assets,  were  $100,000 


THE  INCOME  AND  PROFITS  TAXES 


29 


for  the  year  and  that  the  average  invested  capital  was  $42,000,  the  in¬ 
vested  capital  must  be  reduced  by  .0625%,  or  $26.25,  making  the  invested 
capital,  as  adjusted,  $41,973.75. 

55.  Invested  Capital  of  Reorganized  Business.  In  any  case  of  reor¬ 
ganization,  consolidation,  or  change  of  ownership  after  March  3,  1917, 
of  a  business  or  of  property,  where  any  of  the  same  persons  previously 
interested  in  or  controlling  the  property  or  the  business  retain  an  interest 
or  control  amounting  to  50%  or  more,  the  new  corporation  is  not  allowed 
to  compute  its  invested  capital  the  same  as  if  the  business  had  been  sold 
to  strangers,  but  the  property  received  from  the  previous  owner  must 
be  valued  as  follows:  If  the  previous  owner  wras  a  corporation,  no  asset 
received  from  it  shall  be  included  in  the  invested  capital  at  any  greater 
value  than  would  have  been  allowed  to  it  as  invested  capital  of  the 
prior  corporation.  If  the  previous  owner  w’as  an  individual  or  partner¬ 
ship,  all  assets  transferred  must  be  valued  at  their  cost  wrhen  acquired 
by  such  previous  owner,  with  allowance  for  all  depreciation,  impairment, 
betterment  or  development,  but  with  no  addition  on  account  of  expendi 
tures  deducted  at  any  time  in  computing  taxable  net  income.  The  purpose 
of  this  restriction  is  to  prevent  any  advantage  to  those  wTho  have  reorgan¬ 
ized  their  business  after  the  passage  of  the  first  Excess  Profits  Tax  Law. 
To  illustrate:  Frank  Walsh  was  operating  a  department  store  represent¬ 
ing  an  actual  investment  of  $70,000,  but  actually  worth  $100,000,  because 
of  the  development  of  its  good  will  and  the  increase  in  the  value  of 
its  real  estate.  As  he  needed  more  capital,  he  organized  a  corporation 
which  took  over  the  business  on  July  1,  1917,  for  $100,000  in  stock 
which  was  issued  to  Walsh.  George  Ridgely  and  Daniel  McKay  each 
invested  $40,000  in  cash  and  received  $40,000  in  stock.  The  invested 
capital  of  the  new  company  will  be  $150,000,  although  it  would  have 
been  $180,000  if  the  same  transaction  had  been  carried  out  in  January, 
1917,  or  if  Ridgely  and  McKay  had  taken  a  greater  amount  of  stock 
than  Walsh,  or  had  bought  out  Walsh  for  cash.  The  computation  of 
prewar  income  of  a  reorganized  business  has  already  been  discussed 
at  par.  25. 

PART  3.  DETERMINATION  OF  NET  INCOME. 

56.  Nature  of  Income.  The  law  defines  income  to  include  “gains, 
profits,  and  income  derived  from  salaries,  wages,  or  compensation  for 
personal  services  *  *  *  or  from  professions,  vocations,  trades,  busi¬ 
nesses,  commerce,  or  sales,  or  dealings  in  property  *  *  *  also  from 
interest,  rent,  dividends,  securities,  or  the  transaction  of  any  business 
carried  on  for  gain  or  profit,  or  gains  or  profits  and  income  derived 
from  any  source  whatever.  ”  Income  represents  gains  or  additions  to 
wealth  and  does  not  include  moneys  received  in  return  for,  or  in 
exchange  for,  wealth  already  owned  in  a  different  form.  For  instance, 
if  a  man  receives  $100  in  payment  of  a  note  which  he  has  held  as 
security  for  money  loaned,  such  payment  is  not  income  because  he 
already  was  worth  the  value  of  the  note.  But  if  he  receives  $6  as  one 
year’s  interest  on  that  note,  that  is  income  because  it  is  what  his 
investment  earned  for  him. 


30 


THE  INCOME  AND  PROFITS  TAXES 


57.  Gross  Income  and  Net  Income.  All  that  a  person  receives  in 
the  way  of  gains  or  profits,  with  certain  exceptions  described  by  the 
Act,  makes  up  the  “Gross  Income, ”  which  therefore  means  taxable 
gross  income.  The  entire  salary  received  or  the  entire  sales  of  a 
business  would  be  the  Gross  Income.  The  Act  then  specifies  certain 
“Deductions”  which  are  allowed,  such  as  business  expenses,  losses, 
depreciation,  etc.,  and  the  remainder  is  what  is  called  the  “Net  Income.” 
The  Net  Income  must  be  determined  in  accordance  with  the  instructions 
on  the  Return  and  by  showing  the  total  Gross  Income  and  several  Deduc¬ 
tions.  The  various  exemptions  and  credits,  such  as  the  $2,000  personal 
exemption,  are  then  deducted  from  the  Net  Income  in  computing  the 
tax.  The  Returns  are  revised  from  time  to  time  and  the  reader  should 
study  this  Guide  in  connection  with  the  latest  form  of  Return.  The 
principles  stated  herein,  except  where  qualification  is  made,  are  applic¬ 
able  to  all  persons,  including  corporations  and  partnerships. 

58.  Calendar  and  Fiscal  Year.  Net  Income  is  to  be  determined  for 
the  calendar  year  unless  the  taxpayer  regularly  employs  books  based 
upon*  an  annual  accounting  period  ending  upon  the  last  day  of  some 
month  other  than  December.  If  such  books  are  kept,  the  taxpayer, 
whether  individual,  partnership,  or  corporation,  must  make  the  Return 
in  accordance  with  such  accounting  period,  which  is  called  the  fiscal  year. 
Apparently  a  concern  which  actually  makes  an  annual  closing  of  its 
books  on  a  fiscal  year  basis  is  no  longer  allowed  to  choose,  as  formerly, 
whether  to  report  on  this  basis  or  for  the  calendar  year.  A  fiscal  year 
must  cover  a  twelve  month  period  ending  on  the  last  day  of  a  calendar 
month,  and  an  accounting  period  of  any  other  length  or  not  ending 
on  the  last  day  of  some  month  will  not  be  recognized.  The  Return 
may  sometimes  cover  less  than  twelve  months,  as  where  it  is  the  first 
Return  filed  or  where  the  fiscal  year  is  changed,  but  in  no  case  will  a 
Return  for  more  than  twelve  months  be  allowed.  To  change  from  cal¬ 
endar  year  basis  to  fiscal  year  basis,  or  from  one  fiscal  year  to  another 
or  to  the  calendar  year,  permission  must  be  secured  and  a  Return  must 
be  made  for  the  portion  of  a  year  intervening  between  the  end  of  the  old 
and  the  end  of  the  new  annual  period.  Where  the  Commissioner 
finds  that  a  taxpayer  intends  to  do  any  act  prejudicing  the  col¬ 
lection  of  the  tax,  such  as  concealing  his  property  or  leaving  the 
country,  he  may  declare  the  taxable  year  terminated  and  require  a 
Return. 

59.  Receipt  and  Accrual  Computation.  There  are  two  general 
methods  for  computing  income,  known  as  the  Receipt  Basis  and  the 
Accrual  Basis.  The  first  implies  that  only  the  amounts  actually  received 
and  disbursed  during  the  year  shall  be  included,  while  the  second  recog¬ 
nizes  credits  and  charges  which  have  been  incurred,  even  though  they 
have  not  been  paid  or  even  though  they  are  not  due  or  payable.  For 
example,  if  salary  is  payable  on  January  15  for  the  month  ending  on 
that  day,  the  amount  paid  would,  on  the  Receipt  Basis,  be  regarded 
entirely  as  income  for  the  year  in  which  payment  is  made,  while  on  the 
Accrual  Basis  only  one-half  would  be  reported  for  that  year  and  one- 
half  would  be  charged  in  the  prior  year  when  the  salary  was  being 
earned.  The  Revenue  Act  requires  the  taxpayer  to  use  the  Receipt 


THE  INCOME  AND  PROFITS  TAXES 


31 


Basis  except  where  books  of  account  which  clearly  reflect  the  income 
on  some  other  basis  are  regularly  employed.  In  such  a  case  the  Return 
must  be  made  in  accordance  with  the  books  of  account,  apparently 
without  allowing  the  taxpayer  the  choice  which  he  formerly  had,  of 
using  the  Receipt  Basis  instead.  The  Accrual  Basis  may  be  used  to  a 
greater  or  lesser  extent;  for  example,  although  almost  all  business 
accounts  include,  in  the  income,  sales  made  but  not  collected  for,  and 
very  many  charge  off  during  the  year  only  so  much  of  an  insurance 
premium  as  covers  the  actual  expiration,  less  frequently  taxes  and 
interest  are  charged  on  the  accrual  basis.  No  particular  method  of 
bookkeeping  is  required,  so  long  as  the  actual  facts  are  represented. 
In  any  event,  the  income  should  be  computed  on  the  Return  in  accord¬ 
ance  with  the  books,  except  where  the  books  fail  to  show  the  actual 
income  as  required  by  the  law — for  instance  in  the  item  of  amortization 
which  is  allowed  only  within  prescribed  limitations,  or  in  the  matter 
of  anticipations,  discussed  in  the  next  paragraph. 

60.  Anticipations  and  Reserves.  Both  the  gross  income  and  the 
deductions  must  be  computed  on  the  basis  of  actual  results  and  closed 
transactions,  even  under  the  Accrual  Basis,  and  not  upon  the  basis  of 
prospects  for  the  future.  For  example,  interest  charged  off  must 
actually  relate  to  the  period  covered,  and  it  would  not  be  allowable  to 
charge  against  a  very  profitable  year  interest  or  any  other  expenses 
neither  accrued  nor  paid  until  subsequent  years.  Nor  may  a  charge 
actually  related  to  one  year  be  used  to  reduce  the  income  of  a  later 
year,  even  though  it  was  not  entered  on  the  books  or  on  the  Return  in  the 
proper  year.  Thus  a  reserve  set  up  for  a  contemplated  advertising 
campaign  cannot  be  treated  as  an  accrued  expense.  A  reserve  for  pos¬ 
sible  fire  loss,  shrinkage  in  value  of  inventory,  or  the  estimated  pro¬ 
portion  of  uncollectible  accounts,  does  not  represent  any  loss  actually 
sustained  and  cannot  be  deducted.  Where  such  reserves  are  set  up, 
the  expenses  and  losses  may  be  deducted  when  they  actually  accrue  and 
are  charged  to  the  reserve.  Similarly  a  profit  is  not  taxable  until  it  is 
realized,  and  the  gross  income  should  not  include  the  apparent  gain 
resulting  from  an  appraisal  of  piant  or  property  at  an  increased  value, 
an  increase  in  the  market  price  of  inventoried  merchandise,  an  advance 
in  the  current  price  of  listed  securities  held,  or  any  other  source  of 
purely  “paper  profit.”  In  general,  income  should  include  all  gain  or 
loss  actually  sustained  by  a  closed  transaction,  and  for  this  purpose 
there  is  a  closed  transaction  whenever  there  arises  an  obligation  to 
pay  a  fixed  sum  or  whenever  property  is  taken  as  payment  of  a  fixed 
sum.  Thus  the  exchange  of  real  estate  or  securities  at  agreed  values, 
the  sale  of  property  for  notes,  the  issue  of  stock  with  a  par  value,  or 
the  valid  release  or  compromise  of  indebtedness,  would  constitute  a 
closed  transaction  which  should  be  reflected  in  the  computation  of 
income. 

61.  Constructive  Receipt.  The  Receipt  Basis  is  not  limited  to  receipt 
in  cash  but  includes  payment  made  in  a  substitute  for  money,  and 
credits  available  or  appropriated.  Thus,  even  on  the  Receipt  Basis, 
income  must  include  interest  and  rents  paid  with  notes  or  securities, 
professional  fees  paid  in  real  estate,  wages  paid  partly  by  furnishing 


32 


THE  INCOME  AND  PROFITS  TAXES 


hoard  and  lodging,  partnership  profits  ascertained  and  credited  to  the 
partners,  salaries  or  dividends  credited  to  a  drawing  account,  and  all 
income  for  which  the  recipient  accepts  an  act  or  obligation  as  payment, 
or  which  is  held  subject  to  demand.  There  is  no  constructive  receipt 
where  the  payment  does  not  represent  a  fixed  sum;  for  example,  rent 
based  upon  crop  shares  is  not  regarded  as  income  until  the  crops  received 
have  been  reduced  to  money. 

(A)  Items  Not  Included  in  Gross  Income. 

62.  Nature  of  Excluded  Items.  As  the  term  “ gross  1000010”  is 
used  only  to  refer  to  taxable  gross  income,  it  does  not  include 
gains  which  are  exempt,  because  of  specific  provisions  of  the  statute  or 
because  they  accrued  prior  to  March  1,  1913,  when  the  first  income  tax 
law  went  into  effect.  The  gross  income  also  does  not  include  amounts 
received  which  represent  a  change  in  form  rather  than  an  addition  to 
wealth  and  which  therefore  are  not  gain. 

63.  Gifts.  The  value  of  property  acquired  by  gift,  bequest,  devise, 
or  descent  is  not  included  in  income  of  individuals  or  corporations,  but 
the  income  from  such  property  must  be  included.  A  man  who  inherits 
a  farm  does  not  include  the  value  of  the  farm,  but  all  rents  or  other 
income  received  must  be  included.  Where  a  will  makes  a  gift  of  the 
income  from  an  estate  during  a  specified  period  to  persons  who  are  not 
the  devisees  of  the  principal  of  the  estate,  such  persons  are  not  taxed 
upon  the  amounts  received.  The  voluntary  release  of  a  debt  owing 
by  a  corporation  is  a  gift  to  that  corporation  and  does  not  add  to  its 
gross  income. 

64.  Compensation  for  Personal  Injuries.  Amounts  received  by  an 
individual  as  compensation  for  personal  injuries  or  sickness  are  not 
regarded  as  gains  and  are  not  included  in  the  gross  income.  This 
applies  to  payments  made  under  accident  insurance  policies,  health  insur¬ 
ance  policies,  workmen ’s  compensation  acts,  judgments  for  damages  for 
such  injuries,  and  settlement  or  compromise  agreements. 

65.  Damages  for  Injuries  to  Rights  or  Property.  Damages  recov¬ 
ered  in  any  manner  because  of  injury  to  property,  interference  with 
rights,  or  breach  of  contract,  are  not  income  because  in  the  usual  case 
they  merely  take  the  place  of  wealth  or  capital  without  adding  thereto. 
It  is,  however,  possible  that  the  destruction  of  property  may  result  in 
a  money  compensation  which  amounts  to  more  than  its  cost  (or  value  on 
March  1,  1913),  or  that  the  expected  profit  upon  a  contract  may  be  actually 
realized  by  recovering  for  the  breach.  In  a  case  of  this  kind  the  gain 
will  be  held  taxable.  Special  provision  has  been  made  by  Regulation 
for  allowing  the  replacement  of  property  requisitioned  for  war  use  or 
lost,  destroyed,  or  damaged  through  war  hazards  at  an  advanced  cost 
without  incurring  any  tax  on  the  difference  between  the  cost  and  the 
amount  received  as  compensation,  if  the  entire  amount  received  is 
actually  used  for  replacement  with  similar  property.  If  placed  in  a 
replacement  fund,  established  by  special  permission  in  each  case,  the 
accounting  may  be  deferred  for  a  reasonable  time  until  replacement  is 
practicable. 


THE  INCOME  AND  PROFITS  TAXES 


33 


66.  Proceeds  of  Life  Insurance  Policies.  The  money  received  upon 
a  life  insurance  policy  by  the  estate  of  the  insured  or  by  an  individual 
beneficiary,  at  the  death  of  the  one  insured,  is  not  taxable.  Proceeds  of 
life  insurance  policies  paid  to  corporations  or  partnerships  are  taxable 
as  profit  to  the  extent  that  the  amount  received  exceeds  the  premiums 
paid  and  not  deducted  as  an  expense  in  any  Return  of  income. 
Where  upon  the  maturity  of  an  endowment  policy  or  upon  the 
surrender  of  a  life  insurance  policy  for  cash,  payment  is  made  to  the 
insured  or  some  other  person  who  has  been  paying  the  premiums,  all 
that  is  received  in  excess  of  the  amounts  paid  is  income.  Annuities  are 
subject  to  the  same  rule.  Dividends  on  life  insurance  policies  that  have 
not  matured  are  not  Income,  but  dividends  on  matured  policies  are 
income,  taxed  just  like  dividends  on  corporation  stock. 

67.  Alimony.  An  amount  received  as  alimony  or  separation  allow¬ 
ance  under  a  decree  of  court  or  a  separation  agreement  is  not  to  be 
included  in  the  gross  income  of  the  recipient,  nor  may  it  be  deducted  by 

the  person  who  pays  it. 

68.  Dividends  Received  by  Corporations.  The  amounts  received  by 
a  corporation  as  dividends  upon  stock  in  other  taxable  corporations, 
formerly  included  in  the  net  income,  but  credited  for  certain  taxes,  are 
now  exempted  from  all  taxes  and  are  not  included  in  the  taxable  net 
income.  Although  the  law  provides  that  such  dividends  shall  be  included 
first  in  the  gross  income  and  then  again  in  the  Deductions  from  gross 
income,  it  appears  more  logical  merely  to  exclude  the  dividends  from 
the  gross  income,  and  as  this  may  be  required  by  the  Return  the  point 
is  mentioned  here.  Dividends  received  by  individuals  are  taxed  (see 
par.  116). 

69.  Compensation  of  State  Employees.  The  compensation  of  all  the 
officers  and  employees  of  a  state,  or  political  subdivision  thereof,  are 
exempt  from  tax  and  need  not  be  included  in  gross  income.  This  exemp¬ 
tion  does  not  extend  to  federal  employees,  but  mail  clerks,  postmasters, 
revenue  collectors  and  other  United  States  employees  are  taxed  upon 
their  salaried  incomes.  Pensions  paid  by  the  United  States  Government 
arc  not  exempt. 

70.  Compensation  in  Army  and  Navy.  Gross  income  does  not  include 
so  much  of  the  salary  or  compensation  received  during  the  present  war 
for  active  service  in  the  military  or  naval  forces  of  the  United  States 
as  does  not  exceed  $3,500.  Otherwise,  compensation  of  persons  in  the 
army  or  navy  is  subject  to  tax.  This  exemption  does  not  apply  to 
pensions  or  to  government  allowances  to  families  of  soldiers  or  sailors, 
which  are  taxed,  but  an  allotment  from  exempt  compensation  wTill  also 
be  exempt. 

71.  Income  from  Gold  Mining  and  Sale  of  Oil  Wells  and  Mines. 

The  net  income  derived  from  the  mining  of  gold  by  a  corporation  is 
exempt  from  the  Profits  Tax,  and  the  profit  made  by  selling  mines,  oil 
wells,  gas  w’ells,  or  any  interest  therein,  w’here  the  principal  value  results 
from  prospecting,  exploration  or  discovery  work  done  by  the  taxpayer,  is 
subject  only  to  a  limited  Profits  Tax  in  case  of  a  corporation  and  Surtax 
in  case  of  an  individual,  which  shall  not  exceed  20%  of  the  selling  price. 


34 


THE  INCOME  AND  PROFITS  TAXES 


72.  Interest  on  United  States  Bonds.  The  law  exempts  the  interest 

upon  obligations  of  the  United  States  issued  before  September  1,  1917,  and 
upon  those  issued  after  that  date,  if  and  to  the  extent  provided  in  the 
act  authorizing  the  issue.  Where  such  interest  is  wholly  exempt  it  is 

not  included  in  the  gross  income,  but  if  any  of  the  interest  is  only 

partially  exempt  that  much  of  it  must  be  included  in  the  gross  income 
and  net  income  and  then  shown  in  the  proper  credit  (see  par.  8).  United 
States  bonds  of  the  First  Liberty  Loan  and  all  prior  issues  are  wholly 

tax  exempt.  All  subsequent  issues  are  wholly  exempt  as  to  the  indi¬ 

vidual  Normal  Tax  and  the  corporation  Income  Tax,  and  the  Surtax  upon 
individuals  and  the  Profits  Tax  upon  corporations  do  not  apply  except 
to  the  interest  upon  more  than  $5,000  of  principal  in  one  ownership  of  an 
aggregate  of  Liberty  4%  and  4% %  Bonds  of  the  Second,  Third  and 
Fourth  Loans  or  First  Loan  converted,  War  Savings  Stamps  and  Certifi¬ 
cates  of  Indebtedness.  For  two  years  after  the  war  there  is  a  further 
exemption  from  these  taxes  covering  the  interest  upon  additional  obliga¬ 
tions  not  in  excess  of  the  following  amounts  of  principal  in  one  owner¬ 
ship:  $30,000  of  Fourth  4^’s;  $30,000  of  First  314 ’s,  converted  to  4%  ’s 
of  the  issue  of  October  24,  1918;  Second  and  Third  or  First  or  Second 
converted  4’s  and  4^’s,  in  the  aggregate  not  exceeding  $45,000  nor  one 
and  one-half  times  the  amount  of  Fourth  4%  ’s  originally  subscribed  to 
by  the  taxpayer  and  still  owned  at  the  date  of  making  the  Return.  For 
example,  a  corporation  holding  during  1919  $10,000  of  Third  Liberty 
Loan  Bonds  and  $5,000  of  the  Fourth  Loan,  originally  subscribed  for, 
is  not  taxed  upon  any  of  the  interest  received  but  the  interest  upon 
$10,000  of  the  same  bonds  received  more  than  two  years  after  the  end 
of  the  war,  as  proclaimed  by  the  President  after  the  consummation  of 
the  peace  treaties,  will  be  subject  to  the  Profits  Tax. 

73.  Income  from  State  and  Municipal  Securities.  Gross  income  does 
not  include  interest  from  bonds  or  other  obligations  of  the  states  or 
political  subdivisions  of  a  state.  Corporations  as  well  as  individuals 
receive  the  benefit  of  this  exemption.  The  term  “political  subdivision ’ ’ 
includes  any  special  assessment  district  or  division  created  by  the  proper 
authority  of  a  state,  acting  within  its  constitutional  powers,  for  the 
purpose  of  carrying  out  some  public  work  which  is  a  function  of  the 
State  Government.  This  includes  drainage  districts,  school  districts, 
highway  districts,  etc. 

74.  Bonds  of  Public  Utility  Corporations.  The  above  exemption 
extends  only  to  income  derived  from  obligations  of  political  subdivisions 
of  the  states,  and  not  to  the  income  derived  from  securities  of  private 
corporations  conducting  waterworks,  irrigation  projects,  railroads,  street 
railways,  telephones,  light  plants,  or  other  utilities.  Also,  when  a 
municipality  purchases  a  public  utility  subject  to  a  mortgage,  the 
mortgage  retains  its  original  character,  even  though  the  municipality 
pays  the  interest  thereon. 

75.  Bonds  of  Foreign  Governments.  Interest  from  bonds  of  foreign 
governments  is  not  exempt.  Therefore,  coupons  from  English,  French, 
Canadian,  Argentine,  Chinese  or  other  foreign  government  bonds  must 
be  included  in  gross  income. 


THE  INCOME  AND  PROFITS  TAXES 


35 


76.  Federal  Farm  Loan  Act  Securities.  The  Federal  Farm  Loan 
Act,  as  well  as  the  Income  Tax  Act,  provides  that  the  securities  issued 
under  that  act  shall  be  exempt  from  the  Income  Tax.  The  same  is  true 
of  dividends  received  from  Federal  Reserve  Bank  Stock.  These  securities 
are  not,  however,  obligations  of  the  United  States  and  do  not  share  in 
other  exemptions,  such  as  the  privilege  of  being  included  in  invested 
capital,  which  are  conferred  upon  government  securities. 

77.  Bonds  of  War  Finance  Corporation.  Interest  upon  bonds  issued 
by  the  War  Finance  Corporation  is  exempt  if  and  to  the  extent  provided 
in  the  respective  Acts  authorizing  the  issue  thereof. 

(B)  Particular  Items  of  Gross  Income. 

1  Salaries,  Wages,  Commissions,  Fees,  Etc. 

78.  Compensation  Is  Income.  All  forms  of  compensation  for  per¬ 
sonal  services  are  income.  The  full  amount  received  must  be  shown 
as  gross  income  and  any  direct  expenses  which  are  allowable  are  shown 
as  Deductions  from  gross  income.  No  deduction  can  be  made  for  the  cost 
of  training  or  education,  cost  of  living,  or  other  indirect  cost  which  may 
be  involved  in  maintaining  the  ability  to  render  the  services.  Salaries, 
commissions,  professional  fees,  and  other  forms  of  compensation  are 
regarded  as  income  when  received,  regardless  of  when  they  were  earned, 
unless  they  are  accrued  as  income  on  books  regularly  kept  by  the  tax¬ 
payer.  An  agent  on  commission  who  receives  in  January,  1918,  a  large 
amount  in  settlement  of  the  commissions  earned  during  1917,  must  pay 
the  1918  tax  on  that  amount,  although  his  business  transacted  in  1918 
may  actually  be  so  small  that  he  lias  not  earned  any  taxable  net  income 
on  that  year’s  business.  The  compensation  of  an  executor  or  trustee 
should  be  included  in  the  Return  for  the  year  wrhen  it  is  received,  even 
though  the  services  may  have  been  entirely  performed  in  other  years. 
Where  professional  services  are  billed  in  one  year  and  entered  as  income 
in  the  accounts,  they  must  be  reported  as  income  in  that  year,  even  though 
not  collected  until  later.  (For  exempt  salaries,  see  pars.  69-70.) 

79.  Incidental  Benefits.  Living  quarters,  board  and  lodging,  rent, 
or  expenses,  allowed  in  lieu  of  salary,  must  be  accounted  for  as  income. 
Where  the  compensation  for  services  is  paid  in  part  by  furnishing  a 
place  to  live,  food,  clothes,  or  any  form  of  valuable  goods,  the  value  of 
such  benefits  furnished  should  be  estimated  in  money  and  included  in 
income.  When  employees  receive  incidental  benefits  from  their  employ¬ 
ment,  as  for  example,  free  rent,  fuel,  automobile  use,  free  passes,  etc., 
these  constitute  taxable  income  whenever  they  are  in  fact  part  of  the 
employment  contract  and  some  value  is  attached  to  them.  This  does  not 
include  special  expenses  incurred  in  connection  with  the  business  and 
repaid  by  the  employer.  For  example,  a  minister  receiving  a  salary  of 
$1,500  per  year  is  supplied  with  a  furnished  parsonage  with  a  rental 
value  of  $900  per  year.  His  gross  income  is  $2,400.  He  is  sent  by  his 
congregation  to  attend  a  convention  in  a  distant  city,  and  receives  his 
railroad  fare,  hotel  bill,  and  expenses.  These  latter  sums  are  not  income. 
A  commission  deducted  from  the  premium  and  retained  by  a  life  insur- 


THE  INCOME  AND  PROFITS  TAXES 


3G 


ance  agent  for  writing  a  policy  on  liis  own  life  is  income  accruing  to  the 
agent.  Where  the  incidental  benefit  is  received  not  as  compensation  for 
services,  but  because  of  the  ownership  of  a  business  or  of  property,  it 
is  not  income.  Thus  a  farmer  is  not  taxed  on  the  value  of  farm  produce 
consumed  in  the  family  and  a  taxpayer  living  in  a  home  which  he  owns 
is  not  taxed  on  the  rental  value. 

80.  Pensions  and  Pension  Funds.  The  taxable  income  includes 
amounts  received  by  a  retired  worker  as  a  pension  from  a  former 
employer,  since  this  is  additional  payment  for  the  prior  services.  Deduc¬ 
tions  from  salaries  or  wages  made  by  the  employer  to  cover  compulsory 
or  voluntary  contributions  to  pension,  health  benefit,  or  insurance  funds 
should  be  added  to  the  amounts  received  in  reporting  income  subject  to 
tax,  but  the  same  amount  may  be  deducted  from  the  amounts  subse¬ 
quently  received. 

81.  Indefinite  Amount.  Compensation  is  none  the  less  income  where 
the  amount  is  not  fixed,  but  is  settled  arbitrarily.  The  clergyman  who 
officiates  at  a  wedding  or  funeral  receives  only  what  is  offered  to  him. 
His  fees  are  none  the  less  income  and  must  be  included  in  the  Return. 
Where  a  congregation  takes  up  a  subscription  to  supply  its  minister  with 
clothes,  furniture,  or  a  vacation,  it  must  be  determined  in  the  particular 
case  whether  it  is  a  donation,  which  is  not  income,  or  whether  the  com¬ 
pensation  is  otherwise  indefinite  in  amount  and  is  supplemented  by  such 
payments,  making  them  income. 

82.  Gratuities  and  Tips.  Where  a  tip  actually  represents  compensa¬ 
tion  for  services,  it  is  income  of  the  person  receiving  it,  notwithstanding 
that  the  amount  is  optional  to  the  giver.  This  includes  tips  of  waiters, 
bell  boys,  Pullman  porters,  and  others  who  are  customarily  paid  for  their 
services  in  this  way.  Where  tips  are  not  a  general  practice  they  are  a 
donation  and  do  not  purport  to  be  a  compensation.  Gratuities  not  in  the 
form  of  money,  such  as  cigars,  candy  or  other  presents,  are  not  income 
in  any  case,  as  they  are  not  taken  as  representing  money. 

83.  Bonuses.  Profit-sharing  or  bonus  or  other  special  form  of  com¬ 
pensation  is  income,  if  it  is  in  fact  a  payment  for  services,  but  not  if  it  is 
a  gift.  It  is  often  difficult  to  ascertain  whether  sums  paid  by  an  employer 
in  addition  to  the  stated  compensation  are  donations,  or  gifts,  or  whether 
they  are  rewards  for  specially  productive  services,  or  whether  they  are 
merely  a  part  of  a  salary  which  is  contingent  in  amount.  If  the  pay¬ 
ment  is  given  in  return  for  services,  it  is  income  to  the  employee.  If 
it  is  a  gift,  it  is  not  taxable  income.  Circumstances  indicate  whether 
it  is  regarded  by  employer  and  employee  as  gift  or  compensation,  reason¬ 
ableness  in  amount  being  ordinarily  the  controlling  circumstance.  (See 
par.  147.)  Christmas  gifts,  even  though  customarily  and  regularly  made, 
are  not  taxable  income. 

84.  Ostensible  Salaries.  If  an  amount  paid  ostensibly  as  a  salary 
is  in  fact  something  different,  such  as  payment  for  property  or  payment 
of  dividends,  such  amount  should  be  reported  as  the  kind  of  income 
which  it  in  fact  is,  rather  than  as  a  salary.  For  example,  the  owmers  of 
all  the  stock  of  a  corporation  may  agree  to  divide  all  the  profits  under 
the  name  of  salaries.  In  this  case,  the  individuals  w’ould  be  subject 


THE  INCOME  AND  PROFITS  TAXES 


37 


only  to.  the  surtax  upon  the  amounts  paid,  because  they  are  in  fact 
dividends,  and  not  to  the  normal  tax  which  would  apply  if  they  were  in 
fact  salaries.  In  general,  the  income  should  not  be  reported  as  a  salary 
unless  it  is  an  allowable  deduction  under  that  description,  which  is 
described  more  fully  in  par.  146. 

2.  Trades,  Businesses,  Commerce. 

85.  Mercantile  or  Manufacturing  Business.  The  gross  income  of  the 
usual  business  will  consist  of  the  gross  actual  sales,  together  with  income 
received  from  other  sources.  Allowances,  discounts  and  similar  credits 
given  to  purchasers  should  not  be  reported  as  deductions  on  the  Return, 
but  should  be  excluded  in  computing  gross  income,  so  that  the  Return 
will  show  what  was  actually  received  in  the  business  during  the  year. 
Technically  only  the  gross  profit  is  income,  rather  than  the  total  selling 
price,  but  purchases  and  inventories  are  not  expressly  classified  by  the 
Act,  and  are  treated  on  the  Returns  and  in  this  Guide  as  Deductions 
from  gross  income,  together  with  eost  of  manufacturing,  expenses,  losses 
and  other  deductions. 

86.  Installment  Business.  Installment  sales  require  special  consid¬ 
eration,  and  are  governed  by  special  regulations  of  the  Treasury  Depart¬ 
ment  which  apply  without  regard  to  the  method  of  accounting  used  by 
the  taxpayer.  Where  a  different  method  has  been  used  in  the  Return 
for  former  years,  care  must  be  taken  so  that  the  same  amount  will  not 
be  taxed  twice  nor  twice  deducted.  The  requirements  differ  for  personal 
property  and  real  property. 

87.  Chattels  Sold  on  Installments.  In  the  sale  of  books,  furniture, 
clothing  or  like  property  on  deferred  payments,  the  whole  profit  is  appor¬ 
tioned  to  all  of  the  installments  and  is  reported  as  collected.  The  seller 
need  not  include  the  whole  profit  as  soon  as  the  contract  is  made  and  is 
not  allowed  to  collect  the  entire  cost  before  reporting  any  profit.  For 
example,  the  Progress  Piano  Company  sells  for  $150  a  piano  costing 
$50.  It  receives  $10  down  and  $5  a  month.  Its  tax  Return  should 
include  in  the  gross  income  two-thirds  of  the  year’s  total  collections. 
There  will  of  course  be  no  additional  deduction  for  purchases  or  inven¬ 
tories  under  this  plan.  Salesmen’s  commissions,  overhead,  and  similar 
expenses  should  be  included  in  the  Deductions  for  the  year  in  which 
they  are  incurred. 

88.  Real  Estate  Sold  on  Installments.  Real  estate  sales  conveying 
title  are  distinguished  from  sales  when  title  is  retained,  according  to 
the  Regulations.  This,  however,  is  so  much  a  matter  of  form  rather  than 
substance  that  the  distinction  may  be  abandoned  by  the  Treasury 
Department.  Where  the  title  passes  to  the  purchaser  at  the  time  of 
sale,  the  seller  must  include  in  his  gross  income  the  entire  profit,  includ¬ 
ing  amounts  paid  in  notes  or  deferred  under  the  contract,  whether  secured 
by  mortgage  or  not.  If  the  title  remains  in  the  seller,  the  profit  should 
not  be  reported  until  the  price  is  collected;  as  with  personal  property 
each  collection  consists  of  a  proportion  of  profit  and  a  proportion  of 
return  of  capital. 


38 


THE  INCOME  AND  PROFITS  TAXES 


89.  Illustration.  The  Webster  Development  Company  sells  two  tracts 
of  land  in  March,  1918.  The  first  tract  was  purchased  in  1914  for  $30,000 
and  is  sold  in  April,  1918,  for  $60,000,  of  which  $20,000  is  paid  in  cash 
and  the  balance  in  notes  of  $5,000  each,  secured  by  mortgage  and  due 
in  September,  1918,  and  each  six  months  thereafter.  Title  passes  at  once 
to  the  purchaser,  with  mortgage  back.  The  company  is  taxed  in  1918 
on  the  entire  profit  of  $30,000,  although  the  books  of  the  company  treat 
the  first  payments  as  a  return  of  cost  and  do  not  show  any  profit  until 
the  payment  of  the  third  note.  The  second  tract  also  cost  $30,000  and 
is  also  sold  for  $60,000,  with  $20,000  paid  down.  The  company  does  not 
give  a  deed  in  this  case,  however,  but  the  contract  provides  for  a  deed 
when  the  full  price  has  been  paid  and  provides  for  payments  of  $5,000 
every  six  months,  for  w’hich  notes  are  taken.  Because  title  is  reserved, 
the  taxable  income  for  1918  will  not  show  the  wThole  profit  but,  as  the 
profit  is  one-half  of  the  contract  price,  one-half  of  each  collection  will  be 
shown  as  taxable  income,  $10,000  in  March  and  $2,500  in  September, 
1918.  Each  year  another  $5,000  will  be  reported  if  two  $5,000  payments 
are  collected.  This  is  required  even  though  the  company’s  books  in 
this  case  also  show  no  profit  until  after  the  collection  of  $30,000. 

90.  Real  Estate  Subdivisions.  Where  a  tract  of  land  is  divided  into 
lots  or  parcels  for  resale,  the  entire  cost  should  be  divided  among  all 
the  parcels  and  each  sale  should  be  treated  as  a  separate  transaction, 
with  the  proper  gain  or  loss  on  each  sale  included  in  the  income  reported 
for  taxation.  Parts  retained  by  the  subdividers  or  conveyed  in  payment 
of  expenses  must  be  charged  with  the  proportionate  cost  and  the  outside 
sales  can  not  be  applied  against  the  entire  cost  before  computing  profit. 

91.  Adjustment  for  Non-Payment.  Where  the  entire  contract  profit 
has  been  reported  as  taxable  income,  the  default  of  the  purchaser  will 
give  occasion  for  the  deduction  of  the  unpaid  amount  as  a  bad  debt,  if 
it  is  actually  uncollectible.  If  part  only  of  the  profit  has  been  reported, 
the  entire  loss  is  not  deductible,  but  only  so  much  as  represents  unre¬ 
turned  cost.  Uncollected  profit,  having  never  been  treated  as  income,  can 
not  be  treated  as  loss. 

92.  Property  Repossessed.  Where  the  vendor  repossesses  real  or 
personal  property  he  is  not  allowed  to  charge  any  loss  but  must  report, 
as  a  profit  then  realized,  the  amount  previously  received  and  treated  as 
return  of  cost.  For  example,  in  the  second  transaction  of  the  Webster 
Development  Company,  if  there  was  a  cancellation  for  default  after 
$40,000  had  been  paid  and  the  company  secured  the  land  again,  $20,000 
of  the  $40,000,  which  has  been  treated  as  a  return  of  cost,  must  now  be 
shown  as  income  and  there  is  no  loss.  In  the  case  of  personal  property 
there  may  be  physical  deterioration  or  other  loss  in  value  which  should 
be  allowed.  The  Regulations  suggest  a  charge  for  depreciation,  but  as 
this  is  not  always  adequate,  the  vendor  should  be  allowed  to  charge  off 
as  a  loss  all  of  the  unreturned  cost  and  to  show  as  income  the  fair  value 
of  the  property  as  recovered,  or  else  to  show  as  income  only  so  much  of 
the  cost  previously  collected  as  exceeds  the  loss  in  actual  value  of  the 
property. 

93.  Contracting  Business.  The  income  of  a  contracting  business  can 
not  readily  be  ascertained  at  the  time  the  profit  is  received,  where  the 


THE  INCOME  AND  PROFITS  TAXES 


39 


work  extends  over  a  period  of  years  during  which  payments  are  received. 
The  taxpayer  is  therefore  allowed  to  compute  the  net  income  on  the 
basis  of  completed  contracts,  reporting  the  net  profit  upon  jobs  completed 
during  the  year.  The  gross  income  will  include  the  total  amount  payable 
for  each  of  such  jobs,  whether  paid  in  prior  years  or  not  collected  until 
a  subsequent  year,  and  the  deductions  will  include  all  allowable  charges 
on  account  of  such  jobs  in  whatever  year  incurred,  but  none  of  the 
charges  incurred  during  the  year  for  uncompleted  contracts.  Another 
method  which  may  be  used,  at  the  option  of  the  taxpayer,  is  to  include 
in  the  gross  income  an  estimated  percentage  of  the  contract  price  and 
deduct  all  of  the  cost  and  expense  incurred  during  the  year.  Thus,  if 
the  expense  for  the  year  is  estimated  at  20%  of  the  total  expense  which 
will  probably  be  required,  20%  of  the  total  contract  price  should  be 
reported  as  gross  income-  for  the  year  without  regard  to  the  amounts 
actually  received.  If  the  taxpayer  does  not  choose  one  of  these  special 
methods,  the  income  will  be  computed  in  the  ordinary  way  in  accordance 
with  the  regulations  and  the  books  of  account. 

94.  Farming.  When  farm  products  are  sold,  the  entire  receipts  are 
gross  income  and  the  Deductions  include  the  items  of  cost  and  expense. 
Where  the  crop  is  of  such  a  character  that  it  requires  more  than  a  year 
to  produce,  the  deductions  may  be  made  upon  the  crop  basis;  otherwise 
the  deductions  must  be  reported  for  the  year  in  w-hich  they  are  paid  or 
accrued.  Farmers  are  allowed  to  compute  net  income  on  an  inventory 
and  book  basis  where  an  approved  method  of  accounting  is  followed. 
Otherwise  the  return  must  be  made  on  the  basis  of  receipts  and  disburse¬ 
ments,  notwithstanding  that  in  some  cases  the  cost  and  expense  in  con¬ 
nection  with  a  crop  is  largely  or  entirely  incurred  in  the  year  prior  to 
that  in  which  the  crop  is  sold.  A  farmer  need  not  include  in  his  gross 
income  the  value  of  the  farmhouse  occupied  by  his  family  or  the  farm 
produce  consumed,  but  where  produce  is  exchanged  for  merchandise, 
groceries  or  mill  products  for  personal  consumption  or  of  permanent 
value,  the  fair  market  value  of  the  article  received  is  income  just  as 
if  the  produce  were  sold  for  that  amount.  A  person  operating  a  farm 
for  pleasure  or  recreation  and  not  on  a  commercial  basis  should  include 
in  his  gross  income  only  the  excess  of  receipts  over  expenses,  instead 
of  the  gross  receipts,  since  the  expenses  are  not  otherwise  deductible, 
not  having  been  incurred  in  his  business. 

95.  Life  Insurance  Companies.  The  gross  income  of  a  life  insurance 
company  does  not  include  the  total  receipts  from  premiums,  but  there 
is  excluded  the  amount  of  any  premium  received  from  any  individual 
policy  holder  which  is  paid  back  or  credited  as  an  abatement  of 
premium  within  the  taxable  year.  There  are  also  allowed  as  deductions 
the  amounts  required  by  law  to  be  added  to  reserve  and  the  amounts 
paid  upon  policies. 

96.  Income  from  Government  Contracts.  Many  of  the  relief  pro¬ 
visions  of  the  Profits  Tax  LawT  are  not  extended  to  corporations  receiving 
more  than  a  specified  proportion  of  their  income  from  Government 
contracts.  The  law  defines  a  Government  contract  to  be  a  contract 
made  for  the  benefit  of  the  United  States  with  any  department,  bureau, 
officer,  commission,  board,  agency,  or  contractor  of  or  for  the  United 


40 


THE  INCOME  AND  PROFITS  TAXES 


States.  Reference  to  such  contracts  made  between  April  6,  1917,  and 
November  11,  1918,  includes  both  dates  and  includes  all  contracts 
entered  into  during  that  period  which,  although  originally  not  enforce¬ 
able,  have  been  subsequently  validated  or  made  enforceable. 

b  Sales  of  Property. 

97.  Profit  Is  Income.  Where  there  is  a  sale  or  other  disposition  of 
property  which  has  been  held  as  capital  or  principal,  the  entire  price  is 
not  income  but  only  the  profit,  which  is  the  difference  between  cost  and 
selling  price.  If  any  part  of  the  profit  accrued  before  March  1,  1913, 
when  the  first  income  tax  law  went  into  effect,  it  is  not  taxable.  Tax¬ 
able  profit  is  income  of  the  year  in  which  it  is  realized,  notwithstanding 
that  it  may  have  actually  accrued  in  other  years.  There  are,  however, 
indications  in  the  language  used  by  the  United  States  Supreme  Court, 
in  cases  dealing  with  the  laws  of  1909  and  1913,  that  an  income  tax 
law  can  not  lawfully  apply  to  increases  in  value  which  occur  prior  to 
the  effective  date  of  the  law,  even  though  realized  after  that  date.  On 
this  theory,  the  profit  realized  in  1918  would  be  taxed  at  the  rates  in 
effect  when  it  accrued,  but  the  present  law  expressly  requires  the  other 
practice  and  may  not  be  governed  by  the  cases  mentioned. 

98.  Realized  Profit.  A  paper  profit  or  merely  a  bookkeeping  gain, 
not  actually  realized  in  money  or  otherwise  “  cashed  in,  ”  is  not  income. 
Suppose  stocks,  selling  on  the  exchange,  are  bought  at  56  and  at  the  end 
of  the  year  are  selling  at  96;  in  business  talk,  the  fortunate  purchaser 
has  made  a  profit  of  40  points,  but  as  he  has  not  yet  sold  the  stock  this 
profit  may  be  increased  or  decreased  before  it  is  finally  realized,  and  the 
result  may  ultimately  be  such  a  decline  that  the  profit  is  entirely  lost. 
Therefore,  until  there  has  actually  been  a  conclusion  of  the  transaction, 
there  has  been  no  realized  profit  and  no  income  tax  is  imposed.  On  the 
same  principle,  the  Return  should  not  include  as  gain  or  profit  any 
increase  in  value  or  any  other  book  gain  based  upon  appraisal  or  market 
value,  but  not  actually  realized. 

99.  Profit  Accrued  Before  March  1,  1913.  A  profit  accrued  before 
March  1,  1913,  that  is,  before  income  was  taxable,  is  not  taxable  even 
though  it  wTas  realized  after  that  date.  The  fair  market  value  as  of 
March  1,  1913,  is  deducted  from  the  selling  price  of  property  purchased 
before  that  date  to  determine  the  profit.  Suppose  that,  in  1909,  subur¬ 
ban  real  estate  was  bought  for  $8,500.  During  the  next  two  or  three 
years  the  neighborhood  develops  very  rapidly,  so  that  in  1912  the  prop¬ 
erty  is  worth  $12,500  and  similar  pieces  are  sold  for  that  price.  In  1918 
the  land  in  question  is  sold  for  $15,000.  There  is  a  profit  of  $6,500, 
which  is  all  realized  in  1918;  but  it  is  expressly  provided  in  the  law  that 
in  the  case  of  property  acquired  before  March  1,  1913,  the  amount  of 
gain  shall  be  determined  upon  the  basis  of  the  fair  market  price  or 
value  as  of  March  1,  1913.  In  the  transaction  described,  therefore,  the 
taxable  profit  is  only  $2,500,  which  is  income  for  the  year  1918.  In  the 
same  way,  if  there  is  a  dissolution  of  a  corporation,  and  the  stockholders 
receive  much  more  in  return  than  they  originally  invested,  their  taxable 


THE  INCOME  AND  PROFITS  TAXES 


41 


incomes  should  include  only  that  part  of  their  gain  which  remains  after 
deducting  from  the  amount  received,  the  fair  value  of  their  stock  on 
March  1,  1913. 

100.  Determination  of  Value  on  March  1,  1913.  The  Return  must 
state  how  the  fair  value  as  of  March  1,  1913,  is  determined.  Where  there 
is  an  established  market  value,  as  for  stocks  traded  in  upon  an  exchange, 
the  quoted  prices  would  ordinarily  represent  the  fair  value.  In  the 
case  of  real  estate,  machinery,  merchandise,  or  other  property  which 
does  not  have  a  public  market  price,  any  relevant  evidence  may  be  con¬ 
sidered,  such  as  the  opinions  of  experts,  prices  asked  or  offered  for  simi¬ 
lar  property  at  that  time,  or  other  facts.  In  every  case,  this  is  a  ques¬ 
tion  of  fact  to  be  reasonably  and  adequately  established  by  the  tax¬ 
payer.  The  estimated  value  should  not  include  any  prospective  or 
speculative  profits  but  should  represent  the  price  at  which  the  property 
could  have  been  sold  under  all  conditions  then  existing. 

101.  Cost  of  Property.  The  cost  of  property,  as  used  to  determine 
profit,  may  be  the  inventory  value,  where  inventories  are  made  in  accord¬ 
ance  with  the  Regulations.  Cost  will  include,  in  addition  to  the  original 
purchase  price,  expense  incident  to  the  procurement,  holding,  and  dis¬ 
position  (provided  that  such  expense  has  not  been  charged  as  a  deduc¬ 
tion  from  income),  and  must  be  reduced  by'  amounts  charged  against 
income  of  any  year  for  depreciation  or  depiction.  Where  depreciation 
has  been  charged  off,  the  entire  amount  charged  must  be  deducted  from 
original  cost,  because  it  represents  actual  receipts  which  were  treated 
not  as  income  but  as  return  of  cost.  In  buying  real  estate  it  is  neces¬ 
sary  to  pay  brokers’  commissions,  lawyers’  fees,  stamp  taxes,  recording 
fees,  etc.,  which  are  properly  considered  part  of  the  cost  and  should  be 
deducted  from  the  selling  price  in  ascertaining  profit.  Like  expenditures 
in  connection  with  the  sale  may  also  be  deducted.  The  rule  is  the  same 
where  personal  property  is  bought  and  sold  at  a  profit.  Carrying  charges, 
such  as  storage  for  grain,  taxes  for  unoccupied  real  estate,  interest  on 
stock  bought  on  margin,  and  insurance,  if  incident  to  a  buying  and  sell¬ 
ing  transaction  rather  than  a  general  expense,  may  also  be  applied 
against  the  profit.  In  the  same  manner,  if  the  property  has  been  bet¬ 
tered  or  improved,  as  when  a  house  is  repainted,  grain  is  cleaned,  ani¬ 
mals  are  fattened,  or  an  automobile  is  overhauled  (in  order  to  sell  for 
a  higher  price),  the  expense  of  such  improvement  may  be  added  to  the 
cost.  If  the  expenditure  is  for  the  temporary  benefit  of  the  owner,  who 
expects  to  use  and  enjoy  the  improvement  rather  than  to  pass  it  on 
with  the  property',  it  is  a  personal  or  business  expense  and  not  a  part 
of  cost.  Of  course,  if  any  of  these  items  are  deducted  from  gross  income 
when  the  expenditure  is  made,  they  can  not  later  be  considered  in  arriv¬ 
ing  at  profit,  even  though  the  deduction  may  have  been  improperly'  made. 
(See  par.  134.)  They  can  not  be  included  as  a  part  of  the  general 
expense,  and  also  as  part  of  the  cost  of  property'. 

102.  Selling  Price.  The  selling  price  includes  promissory  notes, 
securities,  or  anything  accepted  as  cash.  Except  where  the  special  regu¬ 
lations  for  installment  sales  apply'  (see  pars.  86-88),  notes,  mortgages,  and 
other  deferred  payments  must  be  treated  as  if  the  entire  price  was  paid 
in  cash,  for  the  purpose  of  ascertaining  profit,  and  must  be  included  as 


42 


THE  INCOME  AND  PROFITS  TAXES 


income.  In  case  any  installments  should  be  unpaid  or  any  notes  should 
prove  worthless,  that  amount  may  be  deducted  from  income  in  a  subse¬ 
quent  year,  when  such  losses  occur  and  are  charged  off  as  bad  debts.  The 
sale  of  the  property  is  regarded  as  a  closed  transaction  and  the  collection 
of  the  notes  as  a  new  item. 

103.  Property  Exchanged.  When  property  is  exchanged  for  other 
property  with  a  definite  or  ascertainable  fair  market  value,  or  where  it 
is  valued  by  the  parties  at  a  fair  amount  for  the  purposes  of  the 
exchange,  such  value  must  be  treated  as  the  price  received  for  the 
property  originally  held  to  determine  profit  or  loss  upon  the  exchange, 
and  the  same  amount  is  the  cost  of  the  new  property  in  connection  w'ith 
a  later  sale.  If  there  is  no  valuation  or  market  value,  there  is  no  closed 
transaction  and  the  cost  of  the  original  property  must  be  treated  as  the 
cost  of  the  property  acquired.  Special  provision  is  made  by  the  statute 
for  the  exchange  of  stock  or  securities  in  connection  with  the  reorgan¬ 
ization,  merger,  or  consolidation  of  a  corporation.  (See  par.  110.) 

104.  Sale  of  a  Gift.  A  man  inherits  real  estate  in  1914  wdnch  is 
fairly  worth  $60,000  and  is  valued  at  that  amount  in  the  accounts  of  tfie 
probate  court.  In  1917  the  property  is  sold  at  a  clear  gain  of  $10,000 
over  all  expenses.  This  gain  is  taxable,  as  it  represents  the  income  from 
property  received  as  a  gift  and  not  a  gift  itself.  The  taxable  gain  is  the 
excess  of  the  selling  price  over  the  fair  value  as  of  March  1,  1913,  or  when 
acquired. 

105.  Stocks  and  Securities.  Profit  from  sales  of  stocks  and  securities 
is  income.  Where  stocks  or  other  securities  are  sold  for  more  than  their 
cost,  including  the  expenses  of  purchase  and  sale,  the  difference  is  profit 
and  is  taxable  as  income.  Regardless  of  how  long  the  stock  has  been 
held,  the  entire  profit  is  income  in  the  year  in  which  it  was  received, 
except  to  the  extent  that  the  profit  was  earned  prior  to  March  1,  1913. 

106.  In  and  Out  of  the  Market.  It  is  difficult  to  ascertain  the  amount 

of  profit,  not  only  with  reference  to  the  income  tax  law,  but  even  as  a 
practical  matter,  in  the  case  of  the  person  who  is  ‘‘in  and  out”  of  the 
stock  market  on  a  single  stock  or  on  a  number  of  stocks.  For  example, 
Walter  Hinman  buys  500  shares  of  Airplane  preferred  at  60  in  January, 
1,000  in  February  at  65,  sells  750  in  March  at  70,  buys  1,000  more  in  May 
at  66,  sells  again  in  June  750  at  69,  and  again  in  July  sells  500  at  71.  He 
still  has  500  shares.  The  Treasury  Department  requires  that  wherever 
possible  the  shares  be  identified  by  certificate  number,  and  the  exact 
profit  for  the  particular  certificate  accounted  for.  Frequently,  this  is 
not  possible;  for  instance,  Hinman  may  have  had  a  single  certificate 
issued  in  February  for  his  1,500  shares,  or  again  in  May  for  his  1,750 
shares.  We  do  know  that  he  bought,  altogether,  2,500  shares  and  that 
he  sold  2,000.  The  rule  is  that  the  sales  must  be  charged  against  the 
stock  first  purchased  in  successive  order;  that  is,  the  cost  of  the  2,000 
shares  sold  shall  be  figured  at  the  cost  of  the  first  2,000  bought.  The 
rule  assumes  that  the  first  stock  purchased  is  the  first  stock  sold.  The 
500  shares  which  he  has  retained  are  considered  as  costing  the  price  last 
paid,  this  in  our  illustration  being  66.  Hinman ’s  profits  are  therefore 
$6,000  on  the  first  sale,  $2,250  on  the  second  sale,  and  $2,500  on  the 
last  sale.  v 


THE  INCOME  AND  PROFITS  TAXES 


43 


107.  Profits  Upon  Different  Issues  of  Stock.  Many  people  who  trade 
in  stocks  accept  their  broker’s  account  of  their  balance  without  know¬ 
ing,  after  the  lapse  of  time,  just  which  stock  made  their  profit.  This 
does  not  give  sufficient  data  to  make  a  complete  Return.  If  there  is  a 
profit  on  some  stocks  and  a  loss  on  several  others,  and  the  year  is  closed 
with  a  eredit  balance  and  also  largo  holdings,  which  have  been  in  part 
purchased  with  profits  made  in  the  market,  it  is  obvious  that  the  cash 
balance  alone  does  not  represent  the  income.  The  actual  gains  must  be 
shown,  and  the  prices  actually  paid  for  the  stocks  held  at  the  end  of 
the  year  must  be  known,  so  that  income  for  the  next  vear  may  be  com- 
puted.  All  the  profit  made  in  trading  in  stock,  without  deduction  for 
losses,  should  appear  as  income  on  the  Return.  Suppose  ilinman  buys 
2,000  shares  of  Metal  Boat  Company  stock  at  $35  a  share  and  at  various 
times  during  the  year  sells  as  follows:  500  shares  at  $40,  500  at  $33, 
500  at  $30  and  500  at  $36.  He  has  lost  money,  but  on  the  income  side  of 
his  Return  he  should  account  for  the  $3,000  profit  made  on  the  two  sales. 
As  with  stock,  so  in  the  case  of  any  other  property,  if  there  is  a  sale  at  a 
profit,  income  has  actually  been  received  and  must  be  accounted  for, 
even  though  losses  may  have  been  suffered  upon  other  sales.  Such 
losses,  if  allowable,  can  be  deducted  only  by  including  them  in  the 
Deductions. 

108.  Corporation’s  Treasury  Stock.  The  original  sale  of  unissued 
stock  of  a  corporation  is  a  contribution  of  capital  and  does  not  involve 
profit  or  loss  to  the  corporation  whether  the  stock  is  issued  at  par,  at  a 
premium,  or  at  a  discount.  Where  stock  once  issued  is  returned  to  the 
corporation  as  a  gift  or  otherwise,  to  be  resold  to  provide  capital,  the 
proceeds  are  regarded  as  additional  capital  and  not  income.  Where  a 
corporation  with  power  to  buy  and  hold  its  own  stock  sells  such  stock 
at  more  than  its  cost,  having  carried  the  stock  as  its  property  without 
retiring  it,  it  receives  a  taxable  income.  If  stock  is  purchased  by  a  cor¬ 
poration  and  retired,  later  issue  of  stock  in  place  of  the  cancelled  stock 
is  a  capital  transaction  and  not  a  sale. 

109.  Property  Transferred  to  a  Corporation  as  Capital.  Frequently 
property  is  taken  over  by  a  corporation  in  exchange  for  its  stock,  the 
par  value  of  the  stock  being  sometimes  very  much  more  and  in  other 
cases  very  much  less  than  the  actual  value  of  the  property.  Property 
is  also  conveyed  without  consideration  or  for  a  nominal  consideration.  As 
this  is  done  to  provide  the  capital  of  the  corporation,  the  valuations 
used  are  not  the  true  cost  and  are  not  binding  in  case  the  property  is 
later  sold  by  the  corporation.  In  that  event,  the  taxable  profit  is 
determined  upon  the  basis  of  the  true  value  of  the  property  when 
acquired.  If  this  value  exceeds  the  book  cost,  the  excess  should  be 
entered  on  the  books  as  a  paid-in  surplus.  The  value  for  this  purpose 
represents  also  the  price  received  for  the  property,  upon  which  gain  or 
loss  should  be  computed,  and  also  the  cost  of  the  stock  to  be  used  in 
determining  the  gain  or  loss  of  the  stockholder  upon  the  sale  of  the  stock. 
In  the  ordinary  case  the  par  value  of  stock  issued  for  property  is  pre¬ 
sumed  to  be  its  actual  value,  and  will  be  treated  as  the  price  of  the 
property.  Thus  where  stock  of  a  corporation  is  issued  to  the  incorpo 
rators  for  the  good  will  of  a  business  being  transferred  by  them  to  the 


44 


THE  INCOME  AND  PROFITS  TAXES 


new  company,  the  individuals  will  be  subject  to  income  tax  upon  the 
amount  by  w’hich  the  actual  value  of  the  stock  received  exceeds  the  value 
of  the  good  will  on  March  1,  1913,  if  it  was  then  in  existence  as  an  asset 
of  the  business,  or  its  actual  cost  if  subsequently  acquired.  Any  certifi¬ 
cates  or  affidavits  filed  to  show  that  the  stock  was  fully  paid  up  would, 
of  course,  constitute  evidence  against  any  claim  that  the  stock  was  worth 
less  than  par. 

110.  Stock  Received  Upon  Reorganization  or  Consolidation.  Where 
stock  or  other  securities  in  a  reorganized  or  consolidated  company  is 
received  in  exchange  for  stock  or  securities  of  the  old  company,  this 
is  regarded  as  a  closed  transaction  analogous  to  a  sale.  If  the  aggregate 
par  or  face  value  of  the  securities  received  does  not  exceed  the  par  or 
face  value  of  the  securities  given  in  exchange,  no  profit  or  loss  to  the 
owner  occurs.  If  the  aggregate  par  value  of  the  new  securities  is  less 
than  that  of  the  old,  there  may  be  a  deductible  loss  equal  to  the  difference 
between  the  actual  value  of  the  new  securities  and  the  cost  (or  value  on 
March  1,  1913)  of  the  old  securities.  When  the  aggregate  par  or  face 
value  of  the  new  securities  received  in  any  such  reorganization  exceeds 
the  aggregate  par  or  face  value  of  the  securities  exchanged,  the  excess 
of  par  value  shall  be  taxed  as  a  profit,  to  the  extent  of  the  difference 
between  the  fair  market  value  of  the  new  securities  and  the  value  on 
March  1,  1913,  of  the  original  securities,  or  their  cost  if  they  were  sub¬ 
sequently  acquired.  An  equal  amount  in  par  or  face  value  of  the  new 
securities  shall  be  treated  as  taking  the  place  of  the  securities  given  up, 
and  the  entire  taxable  gain  will  be  regarded  as  the  cost  of  the  remain¬ 
ing  securities  received.  In  the  absence  of  a  showing  to  the  contrary, 
the  par  value  or  book  value  of  the  new  stock  will  be  taken  as  the  actual 
value.  Thus  a  stockholder  turning  in  one  share  of  $100  stock,  for  which' 
he  paid  $250  in  1914,  in  exchange  for  one  share  of  preferred  and  two 
shares  of  common  stock, ‘par  value  $100  each  and  total  fair  market  value 
$320,  in  a  new  company  organized  to  take  over  the  business  and  property 
of  the  old  company,  will  be  assessed  upon  a  profit  of  $70.  One  share 
of  the  new  stock  will  be  held  as  at  a  cost  of  $250,  and  the  other  two  will 
be  considered  as  having  cost  $35  each. 

111.  Effect  of  Stock  Dividend  on  Cost.  After  payment  of  a  stock 
dividend,  the  following  method  of  determining  cost  of  the  new  and  the 
old  stock  must  be  used  to  ascertain  profit  or  loss  in  case  of  sale.  The 
cost  of  the  old  stock  (or  its  value  on  March  1,  1913,  if  previously 
acquired)  is  divided  by  the  total  number  of  shares  of  old  and  new  stock 
and  the  result  is  the  cost  per  share  of  both  the  old  and  the  new  stock. 
To  illustrate:  If  ten  shares  were  purchased  in  1918  at  a  cost  of  $200 
per  share  and  a  stock  dividend  of  ten  shares  was  received  in  that  year, 
the  twenty  shares  of  old  stock  and  new  will  be  regarded  as  costing  $100 
per  share. 


4.  Interest  Received. 

112.  Received  and  Accrued.  Unless  books  are  kept  on  the  Accrual 
Basis,  interest  is  returnable  when  received,  no  matter  when  earned. 
But  interest  credited  or  held  subject  to  call,  as  savings  bank  interest 


THE  INCOME  AND  PROFITS  TAXES 


45 


and  bond  coupons,  is  constructively  received,  that  is,  it  must  be  returned 
as  from  due  date.  Exempt  interest  has  already  been  discussed. 

113.  Interest  on  Bonds  of  Exempt  Corporations.  The  fact  that  a 
certain  corporation  is  itself  exempt  from  tax  upon  its  income  does  not 
exempt  the  interest  received  by  taxable  persons  from  it.  For  example, 
if  a  mutual  benefit  cemetery  company  or  an  incorporated  social  club 
issues  interest-bearing  bonds  to  raise  funds,  individual  owners  of  such 
bonds  must  account  for  the  interest. 

114.  Interest  on  “Tax  Free”  Bonds.  Exempt  securities,  such  as 
municipal  bonds,  should  be  clearly  distinguished  from  tax  free  bonds, 
which  are  so  called  because  they  provide  that  the  interest  will  be  paid 
“free  of  all  taxes”  which  the  debtor  is  required  to  pay  upon  or  with¬ 
hold  from  such  interest.  The  interest  upon  such  bonds  is  fully  taxed 
and  an  individual  owner  will  include  in  his  income  the  entire  amount 
of  the  interest.  But  the  debtor  corporation  or  “ source’ ’  is  required  to 
pay  on  his  behalf  a  tax  of  2%  of  the  interest,  and  the  amount  so  paid 
is  shown  as  a  credit  on  the  Return  of  the  individual  and  applied  toward 
the  total  tax  which  would  otherwise  be  due.  This  payment  at  the  source 
is  required  only  where  a  corporation  agrees  to  pay  the  interest  on  its 
bonds  or  other  obligations  without  deduction  for  any  tax  which  it  may 
be  required  or  permitted  to  pay  thereon  or  retain  therefrom  under  any 
law  of  the  United  States,  or  agrees  to  pay  any  portion  of  the  federal 
income  tax  of  the  owner  of  its  bonds  or  other  obligations,  or  reimburse 
the  owner  for  any  portion  of  such  tax.  It  is  not  required  where  a  claim 
for  exemption  is  filed  nor  where  the  bonds  are  owned  by  a  domestic  cor¬ 
poration,  but  such  a  corporation  may  have  the  benefit  of  the  payment 
where  it  can  show  that  it  was  actually  made.  By  analogy  to  the  rule 
established  with  reference  to  bank  stock  (see  par.  126),  it  would  appear 
that  any  tax  so  paid  at  the  source  should  be  reported  as  additional  inter¬ 
est  by  the  holder,  but  this  has  not  been  required. 

115.  Accrued  Interest  on  Bonds  at  Time  of  Sale.  When  a  bond  is  sold 
between  interest  dates,  the  seller  and  the  purchaser  apportion  the  interest 
becoming  payable,  and  the  amount  earned  up  to  the  date  of  the  sale  is 
paid  by  the  buyer  of  the  bond  to  the  seller.  If  interest  is  payable  every 
six  months,  January  1  and  July  1,  and  the  bond  is  sold  on  April  1,  the 
buyer  will  pay  the  seller  one-half  of  the  interest,  and  that  amount  shall 
be  included  in  the  seller’s  Return  as  interest  received  and  not  as  part  of 
the  profit  on  the  bonds.  The  buyer  should  not  include  the  amount  so  paid 
in  his  computation  of  the  cost  of  the  bond,  but  when  he  receives  the 
interest  payment  in  July,  the  entire  amount  is  not  income  to  him,  but 
only  that  part  in  excess  of  what  he  has  paid  to  the  seller,  and  he  will 
therefore  include  in  his  Return  only  one-half  of  the  interest  received  by 
him. 


5.  Dividends. 

116.  Subject  Only  to  Surtax.  The  amounts  received  by  an  individual 
as  dividends  upon  the  stock  of  domestic  corporations  are  included  in  the 
gross  income  only  for  computing  the  surtax  and  are  not  subject  to  the 
normal  tax.  Dividends  received  by  a  corporation  are  not  subject  to  any 


46 


THE  INCOME  AND  PROFITS  TAXES 


Income  or  Profits  Tax.  This  is  on  the  theory  that  the  dividend  is  a  dis¬ 
tribution  of  income  which  has  been  already  taxed  when  earned  by  the 
paying  corporation.  Dividends  paid  by  foreign  corporations  not  paying 
an  income  tax  to  the  United  States  are  subject  to  all  taxes. 

117.  Defined.  The  law  defines  “  dividend7 1  to  mean  any  distribution 
made  by  a  corporation  out  of  its  earnings  or  profits  and  payable  to  its 
shareholders  or  members  in  cash  or  property  or  stock.  The  ordinary 
form  of  dividend  is  the  periodical  cash  distribution  of  the  current  profits. 
A  dividend  may  be  paid  in  property,  as  when  Liberty  Bonds  are  so  dis¬ 
tributed,  and  it  may  distribute  profits  accumulated  over  a  long  period. 
When  paid  in  new  stock  issued  by  the  paying  corporation  it  is  called  a 
stock  dividend.  When  paid  in  property,  dividends  should  be  reported 
as  the  actual  value  or  fair  market  value  of  the  property  at  the  time  of 
the  distribution.  Dividends  must  be  distinguished  from  bond  interest, 
which  is  an  expense  of  the  corporation  and  not  a  share  in  its  profits. 
If  preferred  stock  is  actually  stock  and  not  a  certificate  of  indebtedness 
under  a  false  name,  it  can  not  bear  interest  but  the  return  is  a  dividend. 
The  gain  realized  by  a  sale  of  stock  or  by  surrendering  it  upon  the 
liquidation  of  the  company  for  more  than  it  cost  is  not  a  dividend  but 
a  profit  which  is  subject  to  all  taxes. 

118.  Profits  Earned  Prior  to  March  1,  1913.  If  a  dividend  represents 
profits  earned  by  the  corporation  prior  to  March  1,  1913,  there  is.  no  tax, 
since  profits  then  on  hand  belonged  in  substance  to  the  shareholders  and 
might  have  been  withdrawn  by  them  without  tax.  But  a  dividend  can 
be  paid  from  a  surplus  then  accumulated  only  after  all  subsequent  profits 
have  been  distributed,  as  the  law  expressly  provides  that  a  dividend 
paid  in  1918  or  subsequent  years  is  deemed  to  have  been  paid  from  earn¬ 
ings  or  profits  accrued  since  February  28,  1913,  if  any  remain  undis¬ 
tributed,  and  such  a  dividend  can  not  be  made  non-taxable  by  declaring 
that  it  is  paid  from  the  prior  surplus  or  by  charging  it  on  the  books 
against  such  surplus.  (See  Illustration  following). 

119.  Taxable  as  Received.  Taxable  dividends,  other  than  stock  divi¬ 
dends,  are  subject  to  the  general  rule  that  income  not  previously 
accounted  for  on  the  Accrual  Basis  is  taxed  as  income  of  the  year  in 
which  received,  and  it  is  not  material  when  the  dividend  wras  declared 
nor  when  the  corporation  earned  the  profits  being  distributed  (provided 
they  were  not  earned  prior  to  March  1,  1913).  It  is  possible  that  the 
law  may  in  this  respect  be  held  invalid  by  the  courts,  in  view  of  certain 
decisions  of  the  Supreme  Court  and  the  fact  that  the  earnings  of  a  cor¬ 
poration  belong  in  substance  to  the  shareholders  as  soon  as  accrued. 

120.  Distributions  Not  from  Profits.  A  distribution  is  not  a  dividend 
and  it  is  not  taxable  when  it  does  not  constitute  a  distribution  of  income 
of  the  corporation,  as  wrhere  a  corporation  reduces  the  par  value  of  its 
stock,  returning  to  every  shareholder  $50  for  each  $100  paid  in,  or  dis¬ 
tributes  a  paid-in  surplus,  received  originally  from  the  stockholders  or  a 
mere  book  surplus,  created  by  carrying  an  asset,  such  as  good  will,  at 
more  than  cost.  A  dividend  from  depreciation  or  depletion  reserve  is  in 
fact  a  reduction  and  impairment  of  capital  and  should  be  so  shown  on  the 
books.  The  law,  however,  makes  any  such  non-taxable  distribution  im- 


THE  INCOME  ANI)  PROFITS  TAXES 


47 


possible  in  any  case  where  the  corporation  has  an  earned  surplus,  no 
matter  how  the  distribution  is  described  by  the  directors  or  shown  on 
the  books,  by  providing  that  “any  distribution  shall  be  deemed  to  have 
been  made  from  earnings  or  profits  unless  all  earnings  and  profits  have 
first  been  distributed."  (See  Illustration  following).  This  does  not 
apply  to  amounts  distributed  in  liquidation  of  the  corporation,  which 
must  be  treated  as  payments  in  exchange  for  stock,  and  any  excess  over 
cost  is  expressly  taxed  as  a  profit  (if  not  accrued  prior  to  March  1, 

1913),  even  though  in  fact  a  large  earned  surplus  may  in  that  way  be 

distributed.  In  all  cases  of  distributions  not  from  profits,  the  amount 
received  should  be  treated  as  a  return  of  cost  or  value  on  March  1, 

1913,  if  previously  acquired,  and  as  taxable  profit  when  in  excess  of 

such  cost  or  value.  When  stock  is  so  distributed,  the  cost  of  the  old 
and  the  new  stock  is  found  by  apportioning  among  all  the  shares  the 
cost  of  the  old  stock  (or  its  value  on  March  1,  1913). 

121.  Illustration  of  Taxation  of  Dividends.  The  Essex  Investment 
Company  had  an  earned  surplus  of  $1,000,000  on  March  1,  1913.  It  added 
$500,000  to  the  surplus  between  that  date  and  December  31,  1916,  and 
$300,000  from  the  operations  of  1917.  In  1917  the  properties  of  the  com¬ 
pany  were  appraised  at  $1,000,000  more  than  their  book  value  and  were 
entered  on  the  books  at  the  appraised  value  as  of  December  31,  1917, 
thereby  increasing  the  surplus.  At  the  same  time,  the  good  will  of  the 
company  was  entered  on  the  books  as  an  asset  at  $1,000,000.  On  January 
3,  1918,  the  directors  declared  a  dividend  of  $2,000,000  as  a  distribution 
of  the  surplus  created  by  the  appraisal  and  good  will  entries,  and  a 
$200,000  dividend  from  the  1917  profits.  The  dividends  were  payable  in 
cash  on  January  5,  1918.  These  dividends  will  be  together  considered 
a  distribution  of  the  entire  surplus  of  $800,000  earned  since  March  1, 
1913,  and  on  this  amount  the  shareholders  will  be  taxed  at  the  1918 
rates.  The  untaxed  remainder  of  the  dividend  will  be  first  applied 
against  the  $1,000,000  surplus  earned  prior  to  March  1,  1913,  and  then 
against  the  created  surplus,  of  which  $400,000  is  distributed.  Subse¬ 
quent  dividends  paid  in  1918  will  represent  first  1918  profits  and  any 
excess  over  1918  profits  earned  at  the  time  of  payment  wrill  be  a  further 
taxfree  distribution  of  the  created  surplus.  Harley  Davis  owns  100 
shares  of  the  stock  of  the  Essex  Investment  Company  and  receives  $110 
per  share,  or  $11,000  upon  the  dividend  described.  Only  8/22  of  this 
amount,  or  $4,000,  will  be  included  in  his  reported  income,  and  on  this 
amount  he  will  pay  the  1918  surtaxes,  $5,000  or  $50  per  share  is  not 
taxed  because  it  is  paid  from  the  profits  accumulated  prior  to  March  1, 
1913.  $2,000  is  not  taxed  because  it  is  not  a  distribution  of  profits.  He 
later  sells  50  shares  of  his  stock  for  $10  a  share  more  than  the  $100 
which  he  originally  paid.  Since  he  received  $20  a  share  from  the  corpora¬ 
tion  on  account  of  the  increase  in  the  value  of  its  good  will  and  other 
property,  he  must  report  a  profit  of  $1,500  or  $30  per  share  on  the  stock 
sold.  On  July  10  he  receives  a  further  dividend  of  $10  a  share,  upon 
the  remaining  50  shares,  and  is  advised  by  the  corporation  that  the 
earnings  of  the  company  for  the  six  months  and  ten  days  of  1918  are 
estimated  at  $100,000,  or  $5  per  share.  Harley  Davis  will  therefore 
report  an  additional  $250  as  dividends  and  the  cost  of  his  50  shares  will 


48 


THE  INCOME  AND  PROFITS  TAXES 


be  reduced  to  $75  per  share  because  of  the  further  distribution  of  the 
created  surplus.  As  they  may  ultimately  be  sold  for  even  less  than  that, 
he  is  not  required  to  report  any  profit  until  the  shares  are  disposed  of. 

122.  Stock  Dividends.  The  law  expressly  provides  that  a  stock  divi¬ 
dend  constitutes  income  to  the  amount  of  the  earnings  or  profits  dis¬ 
tributed,  which  will  be  the  valuation  at  which  the  stock  is  charged 
against  surplus,  usually  the  par  value,  fn  a  recent  decision,  however,  a 
lower  Federal  Court  has  ruled  that  Congress  has  no  authority  to  thus  tax 
stock  dividends.  This  is  in  line  with  previous  decisions  of  the  Supreme 
Court  and  the  prevailing  legal  opinion,  but  the  Treasury  Department  may 
continue  to  act  in  accordance  with  the  language  of  the  statute  until  it 
is  held  unconstitutional  by  the  Supreme  Court,  which  will  soon  pass  upon 
the  question. 

123.  Dividends  from  Personal  Service  Corporations.  In  view  of  the 
special  plan  for  the  taxation  of  personal  service  corporations  (see  par. 
30),  the  shareholder  is  not  taxed  upon  a  distribution  of  profit  of  such  a 
corporation  earned  after  December  31,  1917.  Until  such  exempt  profits 
have  been  distributed,  distributions  are  deemed  to  be  made  therefrom;  but 
after  such  profits  have  been  exhausted,  distributions  are  deemed  to  be 
made  from  profits  accumulated  after  February  28,  1913,  and  prior  to  Jan¬ 
uary  1,  1918,  and  are  taxed  at  the  rates  in  effect  when  received. 

124.  Profits  Unreasonably  Accumulated.  If  the  Treasury  Department 

finds  that  a  corporation  is  formed  or  availed  of  for  the  purpose  of 
preventing  the  imposition  of  the  surtax  by  permitting  the  income  of  the 
corporation  to  unreasonably  accumulate  instead  of  being  distributed, 
the  shareholders  will  be  assessed  (as  in  a  partnership  or  personal  service 
corporation)  upon  the  amount  to  which  they  would  be  entitled  if  the 
profits  were  distributed,  and  the  corporation  itself  will  be  exempt  from 
Income  Tax.  The  corporation  is  not  exempt  from  the  Profits  Tax,  as  a 
personal  service  corporation  would  be,  but  the  amount  of  that  tax  is 
deducted  from  the  net  income  upon  which  the  shareholders  are  assessed. 
When  the  Secretary  of  the  Treasury  certifies  that  in  his  opinion  the 
accumulation  of  profits  is  unreasonable  for  the  purposes  of  the  business, 
that  fact  or  the  fact  that  the  corporation  is  a  mere  holding  company  is 
prima  facie  evidence  of  a  purpose  to  escape  the  surtax.  Every  corpora¬ 
tion  is  required  to  furnish  on  request  a  statement  showing  the  amount 
of  profits  accumulated  and  the  names  and  shares  of  the  persons  entitled 
thereto  in  case  of  distribution. 

125.  Dividend  on  Life  Insurance  Policy.  Life  insurance  policies 
commonly  have  a  so-called  dividend  or  earning  feature.  The  dividend  is, 
in  fact,  a  part  of  the  premium  which  is  returned  to  the  policy  holder 
because  it  was  found  that  the  expense,  losses,  etc.,  of  the  company  were 
not  in  fact  as  heavy  as  had  been  anticipated,  so  that  its  year’s  income 
provided  some  excess  over  its  expense  and  reserve  requirements.  The 
dividend  is  not,  therefore,  a  gain  or  profit,  but  merely  a  discount  or 
refund  from  a  price  paid.  A  life  insurance  policy  dividend  is  not  income 
when  premiums  are  being  paid  on  the  policy,  but  if  the  policy  is  paid  up 
the  dividends  thereafter  are  income. 


THE  INCOME  AND  PROFITS  TAXES 


49 


126.  Special  Forms  of  Dividends.  Private  banks,  limited  partner¬ 
ships,  and  other  associations  not  incorporated  but  operating  under  the 
corporate  form,  are  taxed  as  corporations,  and  therefore  the  earnings 
received  from  such  organizations  are  treated  as  dividends  and  are  exempt 
from  normal  tax  when  received  by  an  individual.  So-called  dividends 
paid  by  co-operative  merchandising  organizations  to  members  or  to 
patrons  generally,  in  proportion  to  the  amount  of  purchases  made,  are  in 
fact  discounts  or  rebates  reducing  the  price  of  the  merchandise  and  are 
not  income  to  the  recipient.  In  many  states,  shares  of  bank  stock  are 
taxed  and  the  bank  is  required  to  pay  the  tax,  although  it  is  in  fact  a 
tax  upon  the  owner  of  the  share.  Therefore,  the  amount  paid  for  him 
by  the  bank,  having  been  used  to  discharge  his  obligation,  is  income 
received  by  him,  and  such  amounts  should  be  included  in  the  stockholder ’s 
Return  as  dividends  received.  A  scrip  or  note  dividend  is  regarded  as 
cash  to  the  face  value  of  the  scrip.  Dividends  payable  in  Liberty  Bonds 
are  not  exempt,  but  are  taxable  income  to  the  market  value  of  the  bonds 
when  distributed. 


6.  Income  From  Other  Sources. 

127.  Rents  and  Royalties.  Gross  income  includes  all  amounts  received 
as  rents  or  royalties  in  compensation  for  the  use  of  property.  Any  con¬ 
sideration  received  in  lieu  of  money  must  be  reported  at  its  cash  value 
when  received.  Crop  shares  are  taxed  for  the  year  in  which  they  are 
reduced  to  money  or  money  equivalent.  A  building  erected  or  other 
permanent  improvement  made  by  a  tenant,  as  part  of  the  rent,  and 
received  by  the  landlord  at  the  end  of  the  term  is  then  to  be  included 
in  the  gross  income  of  the  landlord  at  its  cost  less  actual  depreciation. 
Interest  and  taxes  paid  by  a  tenant  on  behalf  of  the  landlord  are  income 
of  the  landlord  when  paid,  and  may  also  bo  deducted  by  the  landlord 
as  payments  made  by  him.  Ordinary  repairs  made  by  the  tenant  are 
not  income  of  the  landlord  but  expenses  of  the  tenant.  The  value  of 
the  use  of  property  by  the  owner  need  not  be  accounted  for  as  income  of 
the  owner,  nor  may  it  be  deducted  as  rent  paid. 

128.  Partnership  Profits.  A  partnership,  unlike  a  corporation,  has  no 
legal  existence  aside  from  the  members  who  compose  it  and  therefore 
the  income  w’hich  it  receives  belongs  immediately  to  the  partners  with 
no  declaration  of  dividend,  just  as  if  received  directly  by  them.  The 
income  of  the  partnership  for  the  calendar  year  or  fiscal  year  must  be 
shown  on  a  partnership  Return,  but  only  the  members  are  taxed.  Each 
member  must  show  on  his  individual  Return  his  share  of  the  net  income 
of  the  firm  for  the  period  covered  by  the  last  firm  Return,  even  though 
the  money  may  remain  invested  in  the  business  of  the  firm  and  can  not 
be  drawn  out.  When  the  Return  of  the  partnership  covers  a  fiscal  year 
beginning  in  1917,  the  individual  will  pay  only  the  1917  tax  rates  upon 
that  part  of  his  share  which  is  proportionate  to  the  part  of  the  firm 
fiscal  year  which  falls  within  1917.  This  part  of  the  member’s  share  is 
also  credited  with  the  amount  of  Excess  Profits  Tax  assessed  under  the 
1917  Act  against  the  partnership.  A  similar  rule  applies  in  all  cases 
where  the  fiscal  year  of  the  partnership  falls  in  two  calendar  years  with 
different  rates.  Each  member  receives  credit  for  his  proportion  of  divi- 


50 


THE  INCOME  AND  PROFITS  TAXES 


(lends  and  exempt  interest  received  by  the  partnership,  and  is  allowed 
to  deduct  his  share  of  the  firm ’s  contributions  to  charity,  which  are  not 
deductible  on  the  firm  Return.  As  the  income  is  taxed  when  earned, 
there  is  no  further  tax  when  the  individual  draws  out  his  profits  in 
money.  A  limited  partnership  association  is  treated  like  a  corporation 
and  the  profits  are  taxed  like  dividends,  only  -when  distributed  and  then 
only  for  the  surtax. 

129.  Income  of  Fiduciaries.  The  Return  of  an  individual  must 
include  his  share  in  the  income  received  on  his  behalf  by  a  fiduciary 
(defined  in  par.  39),  whether  such  income  has  been  paid  over  to  him  or 
not.  Amounts  received  from  fiduciaries  as  payment  of  legacies  or  other 
gifts  is  not  income.  The  net  income  shown  on  the  last  Return  filed  by 
the  fiduciary  will  be  reported  by  the  beneficiary  even  though  additional 
amounts  may  have  been  received  since  the  close  of  the  fiscal  year  of 
the  fiduciary  and  before  the  close  of  the  fiscal  year  of  the  beneficiary. 
Where  the  fiscal  year  of  the  fiduciary  falls  within  two  calendar  years  in 
which  different  rates  of  tax  apply,  presumably  the  general  rule  of  appor¬ 
tioning  the  income  would  apply,  although  the  law  is  silent  on  this  point. 
Where  the  beneficiary  receives  income  upon  which  the  fiduciary  or  estate 
has  paid  the  tax,  it  is  not  subject  to  any  further  tax  and  is  not  shown 
on  the  beneficiary ’s  return.  The  beneficiary  receives  credit  for  his 
share  of  the  dividends  and  partially  exempt  interest  received  by  the 
fiduciary. 

130.  Gambling  Gains  and  Illegal  Profits.  Income  includes  amounts 
gained  in  gambling.  Profits  made  in  violation  of  criminal  law  or  public 
regulation  and  income  received  in  violation  of  the  rights  of  individuals 
or  corporations  are  none  the  less  taxable. 

131.  Payment  and  Release  of  Debts.  The  payment  of  a  debt  is  not 
income  to  the  creditor,  since  it  is  a  mere  change  in  form  of  capital. 
Where  one  person  pays  a  debt  owing  by  another,  it  is  either  a  gift  or 
taxable  income  to  the  debtor.  Where  the  debt  of  a  corporation  or  indi¬ 
vidual  is  discharged  or  forgiven  it  may  be  income,  if  for  consideration, 
but  in  the  ordinary  case  of  insolvency  or  reorganization  is  either  a  gift 
or  contribution  of  capital  or  else  a  formal  recognition  of  worthlessness, 
and  in  either  case  would  not  be  taxable  to  the  debtor. 

(C)  Deductions  from  Gross  Income. 

1.  Expenses  of  Carrying  on  Business. 

132.  Nature  of  Expense.  Individuals,  partnerships,  and  corporations 
are  allowed  to  deduct  from  their  taxable  gross  income  “all  the  ordi¬ 
nary  and  necessary  expenses  paid  or  incurred  during  the  taxable  year 
in  carrying  on  any  trade  or  business.”  To  be  included  in  this  deduc¬ 
tion,  a  disbursement  or  charge  must  have  all  of  the  following  qualities: 
(1)  It  must  relate  to  a  trade  or  business  carried  on  by  the  taxpayer; 
this  excludes  personal  expenses,  expenses  of  a  serious  activity  other  than 
a  trade  or  business,  and  expenses  of  the  business  of  another  person, 
paid  by  the  taxpayer  on  behalf  of  the  proprietor.  (2)  The  proceeds  must 
be  such  as  will  be  consumed  or  exhausted  in  a  relatively  short  time,  as 


THE  INCOME  AND  PROFITS  TAXES 


51 


improvements  or  additions  of  permanent  value  are  not  included  in  the 
term  “  expense”  (3)  The  expense  must  be  “ordinary  and  neces¬ 
sary,”  and  expenses  may  be  disallowed  if  unreasonable  in  amount  or 
purpose.  The  deduction  for  expense  should  exclude  all  items,  such  as 
taxes,  which  are  specifically  provided  for  by  the  law  and  the  Returns, 
even  though  in  the  nature  of  expenses,  and  also  certain  expenses  which 
are  expressly  made  not  deductible. 

133.  Personal  Expenses.  The  law  expressly  disallows  the  deduction 
of  “personal,  living,  or  family  expenses,”  which  include  rent  paid  for  a 
home,  wages  of  domestic  servants,  cost  of  food  and  clothing  for  the 
family,  education  of  children,  upkeep  of  pleasure  automobile,  and  similar 
items  connected  in  any  way  writh  the  maintenance,  well-being,  or  pleas¬ 
ure  of  the  taxpayer  or  his  dependents.  Interest,  taxes,  casualty  losses, 
worthless  debts,  and  contributions  to  charitable  organizations  are  deduct¬ 
ible  even  when  entirely  personal  and  not  related  to  a  business,  because 
they  are  the  subject  of  specific  provisions  in  the  law,  explained  later. 
There  have  been  rulings  to  the  effect  that  hotel  bills  paid  by  actors  and 
other  travelers  are  not  allowable  as  deductions  because  they  represent 
food  and  shelter,  which  is  personal,  notwithstanding  the  fact  that  a 
permanent  home  is  necessarily  maintained  elsewhere  by  the  taxpayer. 
Where  such  expenses  are  paid  by  the  employer  they  are  deductible  by 
him  but  may  constitute  additional  income  of  the  employee  (see  par.  79). 

134.  Permanent  Improvements  and  Additions.  The  deduction  for  ex¬ 
pense  may  not  include  investments  of  a  permanent  nature.  Expendi¬ 
tures  for  the  erection  of  buildings,  grading  of  lawns,  and  other  perma¬ 
nent  improvement  of  property,  for  the  installation  of  machinery,  and 
for  the  acquisition  of  books,  tools  or  implements  of  permanent  value 
and  similar  unconsumable  property,  may  not  be  deducted  from  the  gross 
income  since  they  are  merely  a  change  in  form  of  capital  and  not  a 
reduction  of  wealth.  The  test  is  whether  a  capital  asset  is  acquired. 
Under  certain  circumstances,  the  value  of  property  may  so  quickly  dis¬ 
appear  that  it  is  properly  charged  as  expense  even  though  the  physical 
existence  of  the  property  continues  as  in  the  case  of  dies,  patterns, 
or  designs  to  be  used  only  for  a  single  season,  tools  purchased  for 
a  single  job,  and  replacements  of  property  or  parts  not  otherwise  charged 
off.  In  general,  the  cost  is  not  an  expense  where  the  property  will 
continue  in  use  after  the  expiration  of  the  taxable  year,  but  in  certain 
cases  the  cost  may  be  deducted  partly  in  one  year  and  partly  in  the 
next  year  as  a  deferred  expense,  if  correctly  charged  on  the  books  on 
the  accrual  basis.  Where  the  cost  of  property  is  charged  as  expense, 
the  entire  amount  of  salvage  value  or  proceeds  of  sale  must  be  returned 
as  income.  If  desired,  property  of  temporary  usefulness  may  be  carried 
as  an  investment  and  charged  off  by  a  depreciation  or  obsolescence 
allowance,  as  explained  at  pars.  171  and  172.  The  Regulations  hold  that 
the  following  expenditures  must  be  regarded  as  permanent  investments 
and  may  not  be  charged  as  expense:  cost  of  securing  copyright  and  cost 
of  plates;  cost  of  defending  or  perfecting  title  to  property;  cost  of 
plans  and  services  of  architect;  expense  of  organizing  corporation,  pro¬ 
curing  charter  and  selling  stock;  commissions  paid  on  purchase  and  sale 
of  securities  or  other  property  premiums  on  policy  insuring  life  of 


52 


THE  INCOME  AND  PROFITS  TAXES 


employee  or  officer  of  taxpayer  and  premiums  on  endowment  policies;  cost 
of  experimental  and  development  work,  resulting  in  satisfactory  designs, 
drawings,  patterns,  or  models.  These  items  are  of  importance  in  illustrat¬ 
ing  the  rule  that  an  expenditure  resulting  in  a  capital  asset  is  not 
deductible. 

135.  Activities  Other  Than  Business.  “ Trade  or  business”  has  been 
held  to  include  professions  and  vocations.  The  trade  or  business  of  an 
individual  is  the  pursuit  or  occupation  in  which  he  has  invested  money 
and  to  which  he  devotes  part  of  his  time  and  attention  for  the  purpose 
of  a  livelihood  or  profit.  A  single  transaction  or  a  series  of  isolated 
transactions  do  not  constitute  a  trade  or  business.  A  person  may  carry 
on  more  than  one  business  or  trade  if  he  devotes  sufficient  time,  atten¬ 
tion,  and  capital  to  the  enterprise.  Mere  investment  of  capital  for  profit 
is  not  enough.  A  coal  merchant  who  speculates  in  stocks  and  bonds 
is  not  in  the  business  of  dealing  in  such  securities.  A  corporation  acts 
primarily  for  the  sole  purpose  of  carrying  on  a  business  or  trade  and 
all  its  transactions  for  profit  are  part  of  its  business  or  trade.  It  may, 
however,  incur  expenses  which  are  not  directly  connected  with  the  main 
business  but  with  collateral  enterprises,  such  as  the  support  of  legisla¬ 
tion  and  participation  in  public  movements.  There  have  been  decisions 
that  such  expenses  were  not  deductible,  applying  a  narrow  definition  of 
”  trade  or  business.”  Lobbying  expenses  and  campaign  contributions  are 
not  deductible,  but  the  expense  of  belonging  to  commercial  organizations 
is  allowable. 

136.  Unreasonable  Expenses.  In  extreme  cases  expenses  actually  in¬ 
curred  may  be  disallowed  because  they  are  so  unreasonable  in  amount 
or  so  unusual  in  purpose  as  to  cease  to  be  11  ordinary  and  necessary,” 
although  the  managers  of  the  business  considered  them  required  at  the 
time.  It  is  for  this  reason  that  Christmas  presents  and  other  donations 
made  by  corporations  are  not  deductible,  not  being  * 1  necessary.  ”  The 
rule  is  that  an  expense  is  necessary  where  it  is  reasonably  required  by 
the  interests  of  the  business  and  objection  will  rarely  be  made  on  this 
ground  to  anything  short  of  a  donation,  except  where  it  appears  that 
a  business  is  being  used  as  a  cloak  for  disbursements  really  made  for 
another  purpose,  is  being  carelessly  and  extravagantly  inflated,  or  is 
being  unlawfully  despoiled  of  its  property  by  means  of  padded  charges 
made  by  persons  in  control. 

137.  Payment  Basis  or  Accrual  Basis.  Expenses  may  be  deducted 
on  the  payment  basis  or  the  accrual  basis;  that  is,  they  may  be  deducted 
in  the  year  in  which  paid,  or  the  year  in  which  they  become  due  or  are 
incurred  although  not  paid.  If  the  payment  basis  is  used  throughout, 
an  expense  may  be  deducted  in  the  year  in  w’hich  paid,  even  though 
incurred  in  a  prior  year.  Where  the  books  are  kept  on  the  accrual 
basis,  the  expenses  deducted  must  relate  to  the  business  of  the  taxable 
year  and  expenses  not  deducted  in  the  year  in  which  they  are  incurred 
can  not  be  deducted  in  a  subsequent  year  when  paid.  Of  course,  when 
expenses  have  been  previously  deducted  on  the  accrual  basis,  the  subse¬ 
quent  payment  does  not  permit  of  any  further  deduction.  No  deduc¬ 
tion  may  be  made  for  purely  ” paper”  charges,  such  as  rental  value  of 


THE  INCOME  AND  PROFITS  TAXES 


53 


business  property  owned  by  the  proprietor  or  interest  on  the  proprietor ’s 

capital  employed. 

138.  Expenses  of  a  Mercantile  Business.  All  the  ordinary  expenses 
of  a  mercantile  business  may  be  deducted,  including  salaries  (proprietor 
and  employees),  rent,  light  and  heat,  delivery  expense,  advertising,  insur¬ 
ance,  etc.  Interest,  taxes,  losses,  and  depreciation  should  not  be  in¬ 
cluded  as  they  are  covered  by  separate  deductions. 

139.  Cost  of  Merchandise.  Strictly  speaking,  only  the  profit  on  a 
sale  is  income  and  the  Regulations  formerly  required  the  cost  of  goods 
to  be  deducted  from  gross  sales  in  order  to  find  the  gross  income.  At 
present,  however,  cost  of  merchandise  is  treated  on  the  Returns  as  a 
general  deduction.  The  total  purchases  must  be  shown  asVarried  on  the 
books,  either  on  the  payment  basis  or  on  the  accrual  basis,  the  latter 
covering  invoices  charged  to  accounts  payable  during  the  year.  Actual 
prices,  with  discounts  and  allowances  deducted,  should  be  used;  dis¬ 
counts  should  not  be  shown  as  income.  In-freight  may  be  added  to 
cost  or  shown  as  expense.  To  find  the  actual  cost  it  is  necessary  to  add 
to  the  purchases  for  the  year  the  amount  of  the  inventories  at  the  begin¬ 
ning  of  the  year  and  to  deduct  the  inventories  at  the  end  of  the  year. 

140.  Inventories.  Inventories  of  merchandise  held  for  resale  must  be 
used  to  determine  net  income  and  may  be  required  in  any  other  case 
where  the  Commissioner  considers  it  necessary.  Dealers  in  securities  are 
permitted  to  use  inventories  when  regularly  employed  in  the  books  of 
account.  The  basis  to  be  used  may  be  fixed  by  the  R-egulations  so  as 
to  most  clearly  reflect  the  income.  Special  regulations  for  particular 
cases  and  for  special  businesses  are  contemplated  but  at  the  present  time 
the  general  requirements  apply  to  all  businesses.  Inventories  must  be 
taken  in  one  of  two  methods,  either  (1)  at  cost,  or  (2)  at  cost  or  market 
price,  whichever  is  lower.  The  second  method  is  susceptible  of  twTo 
applications,  namely:  (a)  the  entire  stock  may  be  inventoried  at  cost 
and  also  at  market  prices  and  the  lower  of  the  two  inventories  may  be 
used;  (b)  in  each  item  the  particular  goods  may  be  entered  at  the  lower 
figure,  cost  in  some  cases  and  market  price  in  others.  Only  the  second 
of  these  methods  is  recognized  by  the  Treasury  Department.  The  Regula 
tions  do  not  permit  an  inventory  which  will  represent  a  market  value 
wdiieh  is  more  than  cost,  or  a  scaled  down  cost  or  market  value  in  anticipa¬ 
tion  of  future  Josses.  The  basis  of  inventory  which  is  once  adopted  must 
be  adhered  to  in  future  years,  except  where  the  change  is  authorized  by 
the  Commissioner.  Where  inventoried  goods  have  become  obsolete,  dam¬ 
aged,  or  otherwise  reduced  in  value,  they  may  not  be  marked  down  on 
the  inventory  unless  they  are  actually  unsalable,  in  which  event  the 
Return  must  show  the  original  cost,  inventory  value  charged  off,  and 
present  condition. 

141.  Expenses  of  Manufacturing  Business.  The  expenses  of  a  man¬ 
ufacturing  business  include  labor  and  superintendence,  raw  materials, 
supplies,  repairs,  light  and  heat,  pow’er,  selling  cost,  administration  ex¬ 
pense,  and  similar  charges.  Where  the  books  separate  direct  cost  from 
overhead  expense,  the  cost  of  manufacturing  or  producing  goods  for 
sale  should  be  separately  reported  on  the  Return,  but  if  not  separated 


54 


THE  INCOME  AND  PROFITS  TAXES 


on  the  books  may  be  included  in  the  expenses.  Greater  accuracy  is 
attained  where  materials  and  supplies  are  inventoried,  so  that  the  deduc¬ 
tion  will  include  only  the  amount  actually  consumed  during  the  year, 
but  if  no  inventory  or  record  of  consumption  is  kept  it  is  permissible 
to  include  the  total  purchases  made  during  the  year.  Finished  goods 
held  for  sale  must  be  inventoried  and  added  to  the  gross  sales,  and  it  is 
desirable  to  do  the  same  with  wTork  in  process.  All  inventories  must 
be  taken  in  accordance  with  the  requirements  explained  in  the  preceding 
paragraph. 

142.  Expenses  of  Farmers.  An  individual  or  corporation  carrying  on 
the  business  of  farming  may  deduct  amounts  paid  for  labor  used  in 
producing  crops  or  livestock,  cost  of  seed  and  fertilizers,  cost  of  feed, 
repairs  to  buildings,  fences  and  machinery,  expense  of  marketing,  and 
similar  ordinary  and  necessary  expenses.  The  cost  of  farm  machinery 
is  a  permanent  investment,  but  the  cost  of  ordinary  tools,  such  as  spades 
and  pitchforks,  may  be  deducted  as  an  expense.  The  cost  of  stock  pur¬ 
chased  for  resale  is  deductible  in  the  year  when  the  stock  is  sold  to 
determine  profit  or  loss,  but  may  not  at  any  time  be  deducted  as  ex¬ 
pense.  Stock  purchased  for  dairy,  draft  or  breeding  purposes,  is  a  per¬ 
manent  investment,  and  not  deductible.  The  deductible  expenses  must 
be  scheduled  in  the  year  in  which  they  are  paid  or  incurred,  even 
though  the  product  is  not  sold  until  a  subsequent  year,  but  if  incurred 
prior  to  1917  and  not  taken  into  consideration  in  ascertaining  income 
tax  liability,  they  may  be  deducted  in  a  subsequent  year  from  the  sell¬ 
ing  price  of  the  products  to  which  they  relate.  Where  books  are  kept 
according  to  some  approved  method  of  accounting  and  clearly  show  the 
net  income,  the  Return  may  be  made  in  accordance  with  the  books. 
Under  these  circumstances,  inventories  may  be  used.  The  inventory  for 
the  beginning  of  the  year  must  be  the  same  figure  as  that  reported  for 
the  end  of  the  preceding  year.  It  should  include  all  live  stock  and 
products  on  hand,  whether  purchased  or  produced  on  the  farm  and 
whether  held  for  sale  or  permanent  use.  Loss  or  destruction  of  live 
stock  or  products  during  the  year  will  reduce  the  inventory  and  there¬ 
fore  are  deducted  from  income  in  this  wray  and  not  otherwise.  Where 
inventory  is  not  used,  there  may  be  a  deduction  for  the  loss  of  live 
stock  or  products  if  purchased,  but  not  if  produced  on  the  farm  since  in 
that  case  expense  of  producing  has  already  been  deducted.  Products  of 
the  farm  wfill  be  inventoried  at  the  cost  of  production,  based  on  actual 
disbursements  or  at  either  cost  or  market  price,  whichever  is  lower. 
Farmers  using  inventories  are  allowed  a  method  of  deducting  for  shrink¬ 
age  in  value  which  is  not  permitted  in  any  other  case.  Live  stock  held 
for  permanent  use  may  be  included  in  the  inventory  for  each  year  at  a 
figure  which  will  reflect  the  estimated  reduction  in  value  because  of 
increase  in  age  or  other  causes,  such  estimated  reduction  to  be  based 
upon  cost  and  estimated  life. 

143.  Expenses  of  Salaried  Employee.  The  Regulations  provide  that 
expenditures  incurred  in  earning  a  salary  are  deductible  as  business  ex¬ 
penses.  Thus  the  premium  on  a  fidelity  bond  required  by  the  employer  is 
deductible.  But  it  has  been  held  that  the  cost  of  transportation  be¬ 
tween  home  and  place  of  business  is  a  personal  expense,  although  there 


THE  INCOME  AND  PROFITS  TAXES 


55 


is  much  reason  and  authority  to  the  contrary.  Where  a  man  working 
on  salary  or  commission  pays  his  own  office  and  traveling  expenses, 
they  are  of  course  deductible.  Hotel  bills  and  cost  of  meals  have  been 
held  to  be  living  expenses  and  not  business  expenses.  Uniforms  and 
costumes  required  by  the  employment  and  not  adapted  to  personal  use 
are  business  expenses,  but  army  officers  may  not  deduct  the  cost  of 
mounts  and  equipment. 

144.  Expenses  of  Landlords  and  Tenants.  Where  property  is  held 
for  renting  purposes,  the  owner  may  deduct  the  cost  of  securing  tenants 
and  the  expenses  of  maintenance,  such  as  ordinary  repairs,  light  and 
fuel,  janitor  service,  and  insurance.  Where  the  owner  occupies  part  of 
the  building  as  his  dwelling,  the  expenses  must  be  apportioned  and  only 
those  relating  to  the  part  of  the  building  which  is  rented  may  be 
deducted.  A  tenant  may  deduct  the  rent  paid  for  business  premises, 
which  includes  amounts  which  the  lease  requires  the  tenant  to  pay 
on  behalf  of  the  landlord,  such  as  taxes  and  interest.  The  cost  of 
ordinary  repairs  required  to  be  made  by  the  tenant  are  deductible 
by  him  as  expenses,  but  not  as  rent.  Frequently  a  tenant  agrees, 
as  part  of  the  consideration  for  the  lease,  to  erect  a  building  or 
make  other  permanent  improvements  for  the  benefit  of  the  landlord. 
The  cost  of  such  improvement  is  considered  as  rent  and  should  be 
prorated  over  the  term  of  the  lease,  so  that  a  proportionate  amount 
will  be  deducted  in  each  year  of  the  tenancy.  A  deduction  for  deprecia¬ 
tion  by  the  tenant  is  not  allowable  in  such  case,  but  the  cost  of 
ordinary  repairs  and  maintenance  may  be  deducted.  Nor  may  the 
landlord  deduct  for  depreciation,  since  he  does  not  report  the  full  cost 
as  income,  but  only  the  cost  less  depreciation  accrued  at  the  end  of  the 
term  (see  par.  127).  A  premium  paid  to  secure  a  lease  or  an  amount 
paid  for  the  assignment  of  a  leasehold  should  be  prorated  over  the  term 
and  deducted  in  each  year  as  additional  rent. 

145.  Expenses  of  an  Estate.  In  computing  the  net  income  of  a 
trust  estate  or  the  estate  of  a  decedent,  whether  the  estate  itself  is 
taxed  or  whether  the  income  is  divided  among  the  beneficiaries,  no 
deduction  may  be  made  for  the  expenses  of  administering  the  estate, 
such  as  court  costs,  attorneys’  fees,  and  trustee’s  or  executor’s  commis¬ 
sions,  but  these  expenditures  are  regarded  as  reductions  of  the  principal 
of  the  estate.  If  the  estate  is  conducting  a  business,  the  expenses  of 
the  business  may  be  deducted.  Taxes,  interest,  and  similar  items,  may 
also  be  deducted. 

146.  Salaries.  The  statute  allows  the  deduction  of  “a  reasonable 
allowance  for  salaries  or  other  compensation  for  personal  services  ac¬ 
tually  rendered.”  A  payment  is  not  a  salary  if  it  is  in  fact  paid  for 
some  consideration  other  than  personal  services,  as  in  the  following 
examples.  Where  the  stockholders  of  a  corporation  draw  salaries  which 
in  amount  bear  a  close  relationship  to  stock  holdings,  the  payments 
will  be  closely  scrutinized  and  if  found  to  be  in  excess  of  a  reasonable 
payment  for  services  rendered,  the  excess  will  be  regarded  as  a  divi¬ 
dend  paid  under  the  guise  of  salaries.  An  excessive  salary  voted  to  the 
person  or  persons  in  control  of  a  corporation  may  be  held  a  wrongful 
appropriation  of  the  property  of  the  corporation,  which  is  not  deductible 


56 


THE  INCOME  AND  PROFITS  TAXES 


by  the  corporation  although  taxable  to  the  recipient,  as  are  other 
illegal  gains.  Where  a  corporation  buys  out  a  business  and  agrees  to 
pay  salaries  to  the  former  owners,  the  salaries  if  excessive  in  amount 
may  be  held  to  include  payment  for  the  business  or  property  purchased. 
Reasonableness  is  in  all  such  cases  the  controlling  test  of  deductibility; 
the  volume  of  business,  ability  of  the  employee,  responsibility  of  the 
position,  and  all  like  elements,  considered  in  a  bargain  between 
strangers,  may  be  determining  factors.  Where  salaries  paid  exceed  a 
reasonable  amount  the  taxpayer  has  the  burden  of  showing  that  they 
are  actually  and  solely  the  purchase  price  of  services. 

147.  Salary  Fixed  After  Service  Rendered.  Compensation  may  be 
contingent  in  amount,  as  where  it  consists  of  a  percentage  of  sales  or 
profits.  If  the  basis  was  fixed  before  the  services  were  rendered  and 
by  a  free  bargain  influenced  only  by  considerations  affecting  the  value 
of  the  services,  the  salary  may  be  deducted  even  though  the  amount 
may  finally  prove  to  be  greater  than  that  which  would  ordinarily  be 
paid.  Where  the  compensation  is  fixed  after  the  services  are  rendered 
and  independently  of  any  understanding  or  practice,  it  will  not  be 
deductible  if  it  exceeds  a  reasonable  amount  such  as  would  ordinarily 
be  paid  in  other  enterprises  under  like  circumstances.  This  applies  to 
so-called  bonuses,  profit  sharing,  and  other  special  payments  made 
after  the  profitableness  of  the  services  has  been  demonstrated. 

148.  Special  Questions  as  to  Salaries.  For  any  period  prior  to  March 
1,  1918,  reasonable  salaries  may  be  deducted  by  a  corporation  even 
though  not  formally  voted,  provided  they  are  actually  paid  and  are 
properly  charged  back  on  the  books.  Salaries  paid  to  minor  children 
may  not  be  deducted  by  the  parent,  since  he  is  legally  entitled  to  the 
services  and  any  payment  is  in  the  nature  of  a  gratuitous  allowance. 
Salaries  paid  to  employees  who  are  absent  on  military  or  other  govern¬ 
ment  service  for  the  duration  of  the  war  may  be  deducted,  since  they 
tend  to  preserve  the  organization  and  secure  the  return  of  such  em¬ 
ployees.  Compensation  for  services  paid  in  capital  stock  of  the  com¬ 
pany  may  be  deducted  at  the  actual  value  of  the  stock. 

149.  Pensions  and  Compensation  for  Injuries.  Pensions  regularly 
paid  to  employees  or  their  dependents  in  case  of  death,  retirement,  or 
injury,  may  be  deducted,  but  a  mere  gratuity,  such  as  payment  of  the 
salary  of  a  deceased  employee  to  his  widow  in  recognition  of  his  serv¬ 
ice,  may  not  be  deducted.  Compensation  for  injuries,  paid  pursuant  to 
legal  liability  or  pursuant  to  a  settled  practice  in  the  absence  of  liability, 
is  a  deductible  expense.  A  voluntary  contribution  by  an  employer  to  a 
pension  fund  or  insurance  plan  conducted  by  the  employees  is  not  de¬ 
ductible  unless  made  under  circumstances  constituting  it  in  fact  an  ele¬ 
ment  of  the  agreed  compensation  for  services  or  a  settlement  of  a 
liability  of  the  business.  If  the  employer  holds  the  resources  of  such 
a  fund,  only  the  payments  to  the  employees  may  be  deducted  and  not 
the  amounts  appropriated  to  the  fund. 

150.  Donations  and  Gratuities.  Although  it  is  certainly  “ordinary” 
and  usually  considered  “necessary”  to  make  Christmas  presents "  to 
employees  and  others,  they  have  been  held  mere  gratuities  and  not 
deductible  expenses.  Spending  money  furnished  to  salesmen  and  cour- 


THE  INCOME  AND  PROFITS  TAXES 


57 


tesies,  entertainment,  aiul  presents  to  customers  are  deductible  when 
actually  related  to  the  sale  of  goods.  Donations  made  to  charities,  war 
relief,  exhibitions,  and  similar  enterprises  are  not  expenses  and  may  not 
be  deducted  by  corporations  except  where  there  is  a  direct  business 
benefit,  as  where  a  hospital  reserves  a  ward  for  the  treatment  of  em¬ 
ployees,  or  where  an  educational  institution  is  conducted  for  the  benefit 
of  employees  or  their  dependents.  Charitable  contributions  made  by 
individuals  are  deductible  under  a  separate  item  (par.  182).  A  dona¬ 
tion  made  purely  to  obtain  or  preserve  the  good  will  of  customers 
or  the  public  is  not  recognized  as  an  “ordinary  and  necessary”  expense, 
because  the  benefit  is  not  sufficiently  direct.  Campaign  contributions 
are  not  deductible. 

151.  Repairs,  Renewals,  and  Replacements.  Expenditures  for  main¬ 
tenance  and  incidental  repairs,  which  do  not  add  to  the  value  of  prop¬ 
erty  but  merely  keep  it  in  good  condition,  may  be  deducted  as  expense. 
To  the  extent  that  such  repairs  prolong  the  life  of  the  property,  they 
have  the  effect  of  reducing  the  amount  otherwise  chargeable  for  depre¬ 
ciation.  Expenditures  which  add  to  the  value  of  property  are  not 
deductible  but  should  be  charged  as  an  investment  of  capital.  For 
example,  a  worn  part  of  a  machine  may  be  replaced  with  a  more  modern 
part  at  a  materially  higher  cost,  resulting  in  a  machine  of  greater  value. 
The  added  value  because  of  the  new  part  should  then  be  charged  to 
property  account.  An  expenditure  for  restoring  property  or  making 
good  exhaustion  for  which  a  depreciation  charge  has  already  been  made 
may  not  again  be  deducted  from  income  but  must  be  charged  against 
the*  depreciation  reserve.  (See  also  par.  177).  Where  property  is 
replaced  with  other  property  of  a  greater  value,  the  cost  of  replacement 
must  not  be  deducted  from  the  taxable  income  but  should  be  charged  as 
an  addition  to  property  and  used  as  the  basis  for  the  depreciation  deduc¬ 
tion  in  the  future.  At  the  same  time,  however,  a  deduction  may  be 
made  for  the  obsolescence  of  the  discarded  property  (as  explained  at 
par.  164).  For  small  items  the  cost  of  replacement,  where  not  an 
expense  of  maintenance,  may  be  charged  against  the  depreciation  re¬ 
serve,  but  with  large  items  this  is  apt  to  result  in  various  substantial 
errors.  If  the  property  has  not  been  charged  off  and  is  replaced  with 
other  property  of  the  same  value,  the  cost  of  the  new  property  may  be 
charged  off  as  expense,  where  the  effect  is  only  to  maintain  the  prop 
erty  at  its  book  value,  not  to  increase  the  value.  In  this  case,  how¬ 
ever,  the  amount  charged  off  must  be  reduced  by  the  amount  of  any 
depreciation  previously  charged  off  on  the  old  property  and  by  the 
amount  received  for  the  discarded  property  or  its  fair  salvage  value. 
The  cost  of  replacement  should  be  charged  off  as  expense  where  the 
property  has  only  a  short  life  and  where  its  value  disappears  so  quickly 
with  use  that  a  depreciation  charge  is  not  practical.  The  test  is  whether 
there  is  an  addition  to  value  or  capital,  which  is  not  deductible,  or  a 
maintenance  of  value  or  capital,  which  is  expense.  (See  also  par.  134). 
The  application  of  this  test  is  illustrated  by  the  following  case.  The 
Lakeborn  Hotel  Company  entirely  re-furnishes  its  lobby,  charging  the  cost 
to  an  investment  account.  The  old  furniture  is  sold  to  a  second  hand 
dealer  for  a  small  sum.  This  latter  amount  and  the  total  accrued 


58 


THE  INCOME  AND  PROFITS  TAXES 


depreciation  is  deducted  from  the  original  cost  of  the  old  furniture  and 
the  balance  is  charged  off  as  a  loss.  Purchases  of  dining  room  china 
amount  to  more  than  the  original  cost,  but  because  of  breakage,  there 
is  no  more  on  hand  at  the  end  of  the  year  than  at  the  beginning.  There¬ 
fore  the  entire  amount  of  china  purchases  may  be  charged  as  expense, 
with  no  allowance  for  depreciation.  The  company  also  buys  during  the 
year  enough  bedding  and  linen  to  keep  up  its  supply.  If  there  has  been 
an  adequate  depreciation  allowance  the  replacements  may  be  merely 
charged  to  the  property  account  or  the  depreciation  reserve,  but  if  the 
total  cost  of  the  discarded  property  has  not  been  previously  charged  off, 
there  should  be  a  further  deduction  from  income  for  the  loss  in 
discarding  it. 

152.  Life  Insurance  Premiums.  No  deduction  is  allowed  for 
premiums  paid  by  a  business  enterprise  (corporate  or  individual)  to 
insure  the  life  of  an  officer,  employee,  or  any  person  financially  inter¬ 
ested  in  the  business,  where  the  taxpayer  is  directly  or  indirectly  a 
beneficiary.  Such  policy  should  be  treated  as  an  investment.  But  if 
the  insurance  is  for  the  benefit  of  the  employee  who  is  insured,  the 
amount  paid  as  premium  is  an  addition  to  his  compensation  and  is 
deductible.  Where  the  life  of  an  officer  is  insured  to  secure  his  indorse¬ 
ment  of  a  debt  of  the  corporation,  the  premium  paid  is  of  course  an 
addition  to  the  expense  of  borrowing  money,  but  apparently  it  may  not 
be  deducted  because  of  the  express  provision  of  the  statute.  Premiums 
paid  for  term  insurance  are  not  deductible  under  these  circumstances, 
but  since  such  insurance  does  not  have  a  permanent  cash  surrender 
value  it  would  appear  that  a  deductible  loss  is  sustained  when  the 
policy  expires  during  the  life  of  the  insured.  Nevertheless,  the  Depart¬ 
ment  has  advised  that  the  aggregate  premiums  paid  may  not  be  then 
deducted,  as  a  loss  or  otherwise.  Premiums  paid  by  an  individual  to 
insure  the  life  of  himself  or  a  member  of  his  family,  are  of  course 
personal  expenses.  For  the  exemption  applying  to  the  proceeds  of  life 
insurance  policies,  see  par.  66. 

153.  Fire  Insurance  Premiums  and  Reserves.  Premiums  for  fire, 
casualty,  and  other  insurance  are  deductible  when  they  are  expenses  of 
business,  as  when  they  cover  property  used  in  business  or  used  for  rent¬ 
ing  purposes,  but  not  when  they  are  personal  expenses,  as  when  they 
apply  to  a  dwelling  or  a  pleasure  automobile.  Where  a  corporation 
carries  its  own  insurance,  no  deduction  may  be  made  for  amounts  ap¬ 
propriated  to  a  reserve,  which  is  in  fact  only  part  of  the  surplus  set 
aside  for  anticipated  losses,  but  the  proper  deduction  may  be  made 
when  the  losses  actually  occur. 

154.  Organization  and  Capital  Expenses.  All  expenses  incidental  to 
or  connected  with  the  incorporation  and  organization  of  a  corporation 
and  the  sale  of  its  capital  stock  or  securing  or  increasing  its  capital 
must  be  treated  as  the  cost  of  the  franchise  and  must  be  excluded  from 
the  expenses  deducted  from  gross  income,  since  the  Treasury  Department 
holds  that  these  are  capital  transactions  and  not  expenses  of  11  carrying 
on”  business.  Where  a  franchise  has  a  limited  duration  or  is  of  value 
for  only  a  limited  period,  a  deduction  is  allowable  on  the  same  principles 
as  the  amortization  of  a  patent;  or  when  the  corporation  is  finally  liqui- 


THE  INCOME  AND  PROFIT8  TAXES 


59 


dated  and  dissolved,  the  cost  of  the  franchise  may  be  charged  off  as  a 
loss,  since  there  is  an  actual  disappearance  of  property.  A  discount  upon 
stock  sold  or  a  commission  for  the  sale  of  stock,  whether  common  or 
preferred,  may  not  be  deducted  at  any  time  from  the  income  from 
operations,  since  it  has  the  effect  only  to  reduce  the  capital  of  the  com¬ 
pany.  These  items  may  and  should  be  charged  off  on  the  books,  either 
at  once  or  by  deferred  charges,  even  though  reports  to  the  government 
must  then  differ  from  the  books. 

155.  Development  Expenses.  Advertising  and  similar  development 
of  the  good  will  of  a  business  may  properly  be  charged  as  expense, 
even  though  the  result  is  of  permanent  value.  Experimentation  and 
development  of  patterns,  processes,  inventories,  and  similar  work  is 
generally  considered  as  expense,  but  the  regulations  require  that  it  be 
treated  as  an  investment.  It  is  held  that  where  designs,  drawings,  pat¬ 
terns,  or  models  result  in  the  production  of  saleable  goods  they  will 
be  treated  as  a  capital  asset,  and  the  entire  cost,  including  all  experi¬ 
mental  and  development  expenses,  will  be  capitalized  and  not  deducted 
as  expense.  Where  such  designs,  drawings,  patterns,  or  models  prove 
unsatisfactory  and  have  no  asset  value,  the  entire  capitalized  cost  may 
be  deducted  as  a  loss  if  completely  and  satisfactorily  explained  on  the 
Return,  but  may  not  be  deducted  as  expense.  Where  experimental  work 
results  in  patented  inventions,  the  expenditures  for  the  experimental 
work  are  to  be  added  to  the  cost  of  the  patent.  There  are  so  many 
objections  to  carrying  as  an  asset  such  items  as  rent  of  a  laboratory 
or  cost  of  pencils  and  paper  that  a  business  should  charge  off  ordinary 
experiment  and  development  work  for  its  own  purposes,  without  deduct¬ 
ing  the  amount  from  its  income  or  from  its  surplus  as  reported  to  the 
government. 

2.  Interest. 

156.  Deduction  of  Interest  Paid  or  Accrued.  Corporations  and  indi¬ 
viduals  may  deduct  without  limit,  “all  interest  paid  or  accrued  within 
the  taxable  year  on  indebtedness,”  except  for  the  restriction  as  to 
indebtedness  for  carrying  tax-exempt  securities.  Whether  the  accrued 
interest  or  interest  paid  is  the  basis  of  the  deduction  will  depend  on 
the  methods  followed  in  the  books  of  the  taxpayer.  If  interest  accrued 
in  former  years  has  never  been  charged  against  income  it  may  be  de¬ 
ducted  in  the  year  when  paid;  it  may  be  deducted  when  paid  in  advance 
if  at  once  charged  off.  Interest  neither  paid  during  the  year  nor  ac¬ 
crued  for  the  year  can  not  be  made  deductible  merely  by  charging  it  on 
the  books.  The  deduction  may  include  interest  upon  personal  debts, 
such  as  a  mortgage  on  a  dwelling  or  a  judgment  for  a  grocer’s  bill,  as 
well  as  upon  business  debts,  and  also  interest  upon  secured  indebted¬ 
ness.  Banking  corporations  will  include  interest  on  deposits  and  cer¬ 
tificates  of  indebtedness.  Interest  is  not  deductible  in  this  item  unless 
paid  upon  indebtedness  of  the  taxpayer.  For  example,  where  a  cor¬ 
poration  pays  the  interest  upon  a  mortgage  on  property  in  which  it  has 
no  equity  but  which  it  occupies  as  a  tenant,  this  amount  is  deductible 
only  as  an  expense  for  rent.  A  mortgage  debt  upon  property  in  which 
the  taxpayer  has  an  equity  or  to  which  he  is  taking  title  is  construed  as 


00 


THE  INCOME  AND  PROFITS  TAXES 


an  indebtedness  of  the  taxpayer  even  though  not  assumed  by  him. 
Taxes  paid  on  tax-free  bonds  (defined  at  par.  114)  are  in  fact  addi¬ 
tional  interest  or  expense  of  borrowing  money,  but  it  has  been  held 
that  corporations  paying  federal,  state,  or  municipal  taxes  pursuant  to 
such  covenant  will  not  be  allowed  to  deduct  this  payment  under 
any  item. 

157.  Indebtedness  to  Carry  Tax  Exempt  Securities.  The  interest 
deduction  must  not  include  any  interest  paid  on  “indebtedness  incurred 
or  continued  to  purchase  or  carry  obligations  or  securities  (other  than 
obligations  of  the  United  States  issued  after  September  24,  1917)  the 
interest  upon  which  is  wholly  exempt  from  taxation  under  this  title.” 
A  taxpayer  may  not  borrow  money  to  buy  state  or  municipal  bonds, 
use  the  exempt  interest  to  pay  the  interest  on  the  loan,  and  then 
deduct  the  interest  so  paid  from  his  other  income  which  is  taxable. 
Although  the  interest  paid  may  exceed  the  interest  received,  the  excess 
is  not  therefore  deductible  but  the  entire  amount  paid  upon  such  indebt¬ 
edness  must  be  excluded.  Since  shares  of  stock  bear  dividends  and  not 
interest,  there  is  a  question  whether  the  statute  excludes  interest  paid  by 
a  corporation  on  indebtedness  incurred  or  continued  to  carry  dividend¬ 
paying  stock.  Such  interest  would  be  deductible  by  an  individual,  since 
as  to  him  the  dividends  are  not  wholly  exempt,  as  they  are  to  a 
corporation. 

3.  Taxes. 

158.  Taxes  Paid  or  Accrued.  Taxes  assessed  by  the  United  States, 
the  states,  or  political  subdivisions,  excepting  Federal  Income  and 
Profits  Taxes,  may  be  deducted  when  paid  or  accrued.  Special  assess¬ 
ments  for  local  benefits  of  a  kind  tending  to  increase  the  value  of  the 
property  are  excluded  by  the  law  since  they  are  in  fact  the  cost  of  a 
permanent  improvement.  Water  rates  and  like  payments  for  service 
are  not  taxes  but  expenses,  deductible  if  properly  incurred  in  carrying 
on  business.  The  same  is  true  as  to  fees  for  special  privileges  or  per¬ 
mits,  such  as  an  automobile  license  or  an  annual  charge  for  the  use  of 
a  street,  but  where  a  license,  permit,  or  franchise  has  a  permanent  value, 
the  fee  should  be  charged  as  an  investment  and  not  as  a  reduction  of 
income.  Inheritance  taxes  are  not  deductible,  since  they  do  not  reduce 
the  income  of  any  one  but  are.  taken  from  the  principal  in  course  of 
transfer.  Customs  duties  should  be  included  in  the  cost  of  property 
when  possible,  but  when  paid  upon  articles  not  imported  for  sale  they 
may  be  deducted  as  taxes.  Excise  taxes,  stamp  taxes,  and  similar  taxes 
should  be  similarly  treated.  Thus  an  individual  may  deduct  the  war 
tax  paid  upon  theatre  tickets. 

159.  Taxes  on  Bank  Stock  and  Tax  Free  Bonds.  Taxes  are  often 
levied  upon  the  shares  of  stock  in  banks  and  other  corporations,  which 
the  corporation  is  required  to  pay  on  behalf  of  the  owners  of  d;he 
stock.  The  tax  may  not  be  deducted  from  the  income  of  the  corpora¬ 
tion,  but  may  be  deducted  by  the  individual  stockholders  as  taxes  paid. 
On  the  other  hand  they  must  include,  as  part  of  their  income  from 
dividends,  this  same  amount  of  taxes.  This  rule  does  not  prevent  the 
corporation  from  deducting  the  Federal  Capital  Stock  Tax  or  any  state 


THE  INCOME  AND  PROFITS  TAXES 


61 


excise  or  franchise  tax,  paid  to  transact  business  within  the  state, 
imposed  upon  the  corporation  itself  but  based  upon  the  value  of  the 
shares.  Likewise,  taxes  paid  on  behalf  of  the  holders  of  tax-free  bonds 
(defined  at  par.  114)  are  not  deductible  by  the  corporation,  but  the 
holders  of  the  bond  may  deduct  any  taxes  so  paid  other  than  the  Federal 
Income  Tax. 

160.  Foreign  Taxes.  Deductible  taxes,  in  the  case  of  a  citizen,  resi¬ 
dent  alien,  or  domestic  corporation,  include  also  those  assessed  by  for¬ 
eign  countries,  other  than  income  or  profits  taxes.  Income  or  profits 
taxes  assessed  by  a  foreign  country  or  a  possession  of  the  United  States 
against  a  domestic  corporation  or  a  citizen  (or  assessed  by  a  possession 
of  the  United  States  against  a  resident  alien)  are  credited  toward  the 
tax  found  to  be  due  upon  the  net  income  computed  with  no  deduction 
for  such  tax.  To  illustrate:  Where  the  Return  of  a  nonresident  citi¬ 
zen  shows  a  net  income  of  $30,000,  after  deducting  property  and  personal 
taxes  paid  to  foreign  countries,  and  a  tax  liability  of  $1,450,  and  also 
shows  that  an  income  tax  of  $980  was  paid  during  the  taxable  year  to 
the  government  of  the  foreign  country  where  the  citizen  resides,  the 
foreign  tax  would  be  deducted  from  the  amount  otherwise  due,  leaving 
the  United  States  tax  $470.  A  foreign  corporation  or  nonresident  alien 
is  not  allowed  this  credit.  A  resident  alien  is  allowed  a  similar  credit 
for  such  tax  assessed  by  the  country  of  which  he  is  a  citizen  or  sub¬ 
ject,  on  condition  that  a  like  credit  is  allowed  by  that  country  to  citizens 
of  the  United  States  residing  there.  A  domestic  corporation  will  be 
allowed  similar  credit  for  a  proportion  of  income  or  profits  taxes  paid 
by  a  foreign  corporation  of  which  it  owns  a  majority  of  the  voting  stock, 
to  any  foreign  country  upon  income  derived  from  foreign  sources.  The 
proportion  shall  be  the  same  as  that  which  the  amount  of  dividends,  not 
exempt  from  tax,  received  by  the  domestic  corporation,  bears  to  the 
total  income  of  the  foreign  corporation  upon  which  the  foreign  taxes 
were  paid.  The  amount  of  this  credit  shall  in  no  case  exceed  the  amount 
of  taxable  dividends  received  by  the  domestic  corporation. 

t 

4.  Losses. 

161.  Losses  Sustained.  Losses  must  be  separately  reported,  with 
the  explanations  required  by  the  Regulations,  and  should  not  be  in¬ 
cluded  in  the  Expenses  or  in  any  other  deduction.  Common  to  the  vari¬ 
ous  kinds  of  deductible  losses  is  the  requirement  that  they  be  sustained. 
It  is  held  that  a  loss  is  not  “  sustained’ ’  when  it  reflects  a  speculative  or 
fluctuating  valuation  of  a  continuing  investment,  but  only  after  it  has 
been  determined  and  ascertained  upon  an  actual,  completed,  and  closed 
transaction,  and  after  the  amount  involved  has  irredeemably  disap¬ 
peared  from  the  assets  of  the  taxpayer.  A  person  may  feel  certain  that 
real  estate  which  he  owns  is  worth  much  less  than  when  he  bought  it, 
or  that  some  of  the  stock  in  his  store  will  never  be  sold  until  he  marks 
it  below  cost,  and  it  would  ordinarily  be  said  that  he  had  lost  money 
in  both  cases.  But  no  deduction  may  be  made  for  anticipated  losses, 
however  probable,  for  which  reserves  are  set  up,  nor  for  shrinkage  in 
the  value  of  the  property  until  made  absolute  by  sale  or  disposition  of 


62 


THE  INCOME  AND  PROFITS  TAXES 


the  property,  even  though  such  shrinkage  may  be  charged  upon  the 
books  and  proved  by  expert  appraisal  or  other  evidence  of  the  highest 
credibility.  (See  par.  60).  This  rule  applies  to  corporations  as  well 
as  to  individuals. 

162.  Kinds  of  Losses.  Individuals  must  separately  report:  (1) 
losses  incurred  in  trade  or  business;  .  (2)  losses  incurred  in  a  transac¬ 
tion  entered  into  for  profit  but  not  connected  with  the  trade  or  busi¬ 
ness;  (3)  losses  not  connected  with  the  trade  or  business  arising  from 
fire,  storm,  shipwreck  or  other  casualty  or  from  theft;  (4)  debts  ascer¬ 
tained  to  be  worthless  and  charged  off.  As  to  corporations,  the  law  dis¬ 
tinguishes  only  between  debts  charged  off  and  other  losses.  To  the 
extent  that  a  loss  is  covered  by  insurance,  there  is  of  course  no  loss  to 
the  owTner.  Losses  may  be  deducted  only  in  the  year  in  which  they  are 
incurred,  even  though  the  cost  of  replacing  the  asset  which  the  loss  rep¬ 
resents  is  properly  distributed  over  several  years.  For  example  if  a 
dwelling  house  burns  down  and  is  not  covered  by  insurance,  the  loss 
sustained  must  be  deducted  from  the  income  of  the  same  year.  If  the 
value  of  the  destroyed  house  is  more  than  the  entire  year’s  income  of 
the  owner,  he  is  not  entitled  because  of  that  fact  to  deduct  part  of  the 
loss  in  one  year  and  part  in  the  next.  (But  see  pars.  165-166.) 

163.  Loss  on  Sale  of  Property.  The  loss  sustained  by  the  sale  of 
property  is  determined  according  to  the  same  rules  wdiich  apply  with 
reference  to  profit  (pars.  97-111).  Loss  of  this  kind  consists  in  gen¬ 
eral  of  the  difference  between  the  selling  price  and  the  cost,  except 
that  cost  and  selling  price  must  be  ascertained  in  the  same  manner  as 
has  been  explained  with  reference  to  profit  and  where  the  property  w’as 
owned  prior  to  March  1,  1913,  the  value  of  that  date  is  used  instead  of 
the  cost. 

164.  Losses  on  Obsolete  and  Discarded  Property.  Where  old  build¬ 
ings  are  removed  or  old  machinery  or  equipment  is  scrapped,  to  be  re¬ 
placed  by  similar  property  or  merely  to  be  withdrawn  from  use,  a 
deduction  may  be  made  for  the  loss  sustained,  since,  this  is  regarded  as  a 
closed  transaction  if  the  property  definitely  and  finally  disappears  from 
the  assets  of  the  taxpayer.  It  is  held,  howrever,  that  where  real  estate 
is  purchased  for  the  purpose  of  erecting  new  buildings,  no  deductible 
loss  is  sustained  by  reason  of  the  destruction  of  an  old  building  stand¬ 
ing  upon  the  real  estate,  but  the  sum  of  the  cost  of  the  real  estate  and 
old  building  and  the  cost  of  removing  the  old  building  will  be  con¬ 
sidered  the  cost  of  the  real  estate,  or  the  amount  paid  for  the  old 
building  and  the  destruction  of  it  may  be  included  in  the  cost  of  the 
new  building  being  erected.  The  loss  when  property  is  destroyed  or  dis¬ 
carded  is  determined  by  deducting  from  the  cost  of  the  property  (as 
defined  in  par.  101);  or  its  value  on  March  1,  1913,  the  sum  of  (1)  the 
amount  received  for  the  property  wThen  it  is  disposed  of  or  its  fair  salvage 
value  at  that  time  if  no  sale  is  made,  (2)  the  total  amount  that  has 
been  previously  deducted  and  claimed  on  account  of  the  depreciation 
or  obsolescence  of  the  property,  (3)  any  additional  amount  of  deprecia¬ 
tion  actually  sustained  and  wrhich  might  have  been  deducted,  but  wrhich 
has  never  been  charged  off.  (See  Illustration  at  par.  209).  The  de¬ 
duction  for  loss  in  the  taxable  year  may  not  include  any  amounts  which 


THE  iKCOME  AND  PROFITS  TAXES 


63 


were  actually  lost  by  reason  of  the  depreciation  of  the  property  in  prior 
years,  but  such  depreciation  must  be  claimed  for  the  year  in  which  it 
occurred.  In  this  connection  it  must  be  remembered  that  allowable 
depreciation  formerly  covered  only  physical  wear  and  tear,  and  a  charge 
to  cover  anticipated  obsolescence  has  not  been  recognized  as  an  allow¬ 
able  deduction.  Therefore  the  loss  sustained  upon  discarded  property 
would  not  be  reduced  by  reason  of  the  fact  that  it  included  obsolescence 
which  has  been  gradually  occurring  over  a  period  of  years.  The  amount 
deducted  must  be  properly  recorded  on  the  books  of  the  taxpayer  and  tho 
Return  must  be  accompanied  by  a  statement  showing  the  facts  in  sufli- 
cient  detail  to  clearly  establish  the  amount  and  fact  of  the  loss.  Where 
patents  are  found  to  be  entirely  worthless  before  their  cost  has  been 
charged  off  by  means  of  the  allowable  depreciation  deduction,  the 
balance  may  also  be  deducted  as  a  loss  in  this  way.  The  same  method 
governs  the  determination  of  loss  where  property  is  damaged  or  destroyed. 
No  deductions  are  allowed  for  damage  or  reduction  in  the  value  of 
merchandise  or  material  carried  in  stock  until  it  becomes  unsalable  or 
unusable  by  reason  of  obsolescence  or  damage.  When  this  condition 
exists,  the  deduction  of  the  cost  or  inventory  value  may  be  claimed 
as  a  loss. 

165.  Credit  for  Losses  of  Another  Year.  Income  Taxes  for  one  year 
may  be  reduced  on  account  of  losses  in  excess  of  income,  sustained  in 
a  taxable  year  beginning  after  October  31,  1918,  and  ending  before 
January  1,  1920,  if  in  connection  with  (a)  operation  of  a  business 
regularly  carried  on  by  the  taxpayer  or  (b)  the  sale  of  plants  or  facilities 
acquired  after  April  5,  1917,  and  used  in  the  production  of  articles  con¬ 
tributing  to  the  prosecution  of  the  war.  If  the  income  of  the  year  is 
sufficient  to  cover  the  losses  sustained  in  that  year,  the  entire  deduction 
must  be  made  from  the  current  income,  but  where  the  losses  exceed  the 
income  as  otherwise  computed,  the  difference  or  net  loss  for  the  year 
when  proved  by  satisfactory  evidence  may  be  used  to  reduce  the  taxable 
net  income  of  the  preceding  year  under  this  provision,  and  the  taxes  paid 
for  that  year  shall  be  refunded  accordingly.  Where  the  loss  exceeds 
the  income  of  the  preceding  year  the  excess  shall  be  deducted  from  the 
income  of  the  succeeding  year.  The  net  loss,  as  reported  upon  income 
tax  returns,  must  be  reduced  by  the  amount  of  untaxable  interest  and 
dividends  received  during  the  same  year  the  loss  was  suffered. 
The  provisions  extend  to  the  members  of  partnerships  and  the  bene- 
liciaries  of  estates  which  sustain  net  losses. 

166.  Loss  in  Value  of  Inventory.  A  reduction  in  the  value  of  the 
inventory  of  a  business,  which  occurs  during  the  taxable  year  is  of  course 
reflected  in  the  net  income  if  the  goods  in  question  are  sold  during  the 
taxable  year  and  is  also  reflected  in  the  income  if  the  inventory  at  the 
end  of  the  year  is  taken  at  the  market  price  when  lower  than  cost.  If 
the  reduction  in  the  value  of  the  inventory  occurs  in  the  following  year, 
the  loss  would  normally  reduce  the  taxable  income  of  that  year  in  the 
same  manner,  but  a  special  provision,  due  to  the  inflation  of  prices  result¬ 
ing  from  war  conditions,  permits  the  adjustment  of  the  Return  for  the 
taxable  year  ending  in  1918  wrhere  the  inventory  for  the  end  of  that 
year  is  the  subject  of  a  substantial  reduction  which  actually  occurs  in 


64 


THE  INCOME  AND  PROFITS  TAXES 


the  following  year.  It  is  not  necessary  that  such  reduction  be  realized 
by  sale,  but  it  must  be  proved  by  evidence  satisfactory  to  the  Com¬ 
missioner.  The  reduction  must  be  material  and  must  not  oe  a  temporary 
fluctuation.  A  readjustment  of  the  same  kind  will  be  made  where  rebates 
are  paid  in  1919  upon  sales  made  and  accounted  for  in  1918,  if  the  pay¬ 
ment  is  pursuant  to  contracts  made  in  1918.  In  advance  of  interpretation 
of  the  law,  it  is  impossible  to  state  what  requirements  will  be  made 
or  what  restrictions  will  be  imposed  as  to  the  identity  of  the  goods 
inventoried  and  the  goods  held  at  the  time  the  reduction  occurs. 
Obviously  the  amount  wrhich  is  deducted  from  the  income  of  the  first 
year  must  also  be  deducted  trom  the  figures  used  to  determine  the 
profit  of  the  second  year. 

167.  Worthless  Debts.  Bad  debts,  which  have  been  actually  ascer¬ 
tained  to  be  worthless  and  ,have  been  charged  off  during  the  year,  may 
be  deducted.  The  Return  must  show  some  evidence  of  the  manner  in 
which  the  worthlessness  was  ascertained,  that  is,  it  should  state  that  the 
debtor  was  discharged  in  bankruptcy  or  disappeared  leaving  no  property, 
or  that  the  ordinary  methods  of  collection  have  been  exhausted,  or 
similar  facts.  If  the  bad  debt  represents  taxable  income,  the  deduction 
will  be  allowed  only  if  the  sum  has  been  included  in  a  Return  of  Income. 
A  man  takes  a  promissory  note  for  two  months  ’  salary  in  1916,  but  does 
not  include  it  in  the  Return  as  income.  In  1917,  he  actually  ascertains 
that  note  is  worthless  and  attempts  to  deduct  it  from  his  income  for  that 
year.  The  deduction  will  not  be  allowed  because  the  debt,  if  collected, 
would  be  taxable  income,  and  the  fact  that  some  expected  income  is  not 
received  does  not  reduce  the  income.  But  the  rule  is  otherwise,  if  the 
note  has  been  taken  for  a  loan;  then  the  payment  wTould  not  be  income 
when  received  and  the  failure  to  collect  results  in  an  allowable  deduction. 

168.  Losses  on  Securities.  Bonds  are  debts,  and  when  they  are  ascer¬ 
tained  to  be  worthless  and  charged  off,  the  face  amount  may  be  deducted. 
Stocks  are  not  debts  and  when  they  become  worthless  there  can  be  no 
deduction  except  for  the  loss  realized  -when  they  are  sold,  or  when  they 
cease  to  exist  as  property  because  of  the  dissolution  of  the  corporation. 
Losses  incurred  in  the  sale  of  bonds  and  stocks  are  ascertained  according 
to  the  principles  applying  to  other  kinds  of  property,  but  no  .deductible 
loss  arises  merely  because  the  market  value  of  securities  has  decreased. 

169.  Bonds  Issued  at  Discount  or  Redeemed  at  Premium.  A  corpora¬ 
tion  may  deduct  the  loss  incurred  in  selling  its  own  bonds  below  par. 
Suppose  the  Fidelity  Corporation  issues  bonds  for  $960  each,  which  it 
must  pay  in  ten  years  at  $1,000  each.  There  is  obviously  a  loss  of  $40 
on  each  bond  and,  although  the  loss  is  not  actually  sustained  until  the 
bonds  are  paid,  the  liability  accrues  at  once  and  the  corporation  is  allowed 
to  prorate  the  loss  over  the  life  of  the  bonds,  deducting  in  each  year 
one-tenth  of  this  loss.  It  is  not  permissible  to  deduct  the  entire  amount 
the  first  year.  The  same  rule  applies  to  selling  commissions  and  other 
expenses  incurred  in  issuing  the  bonds.  The  premium  paid  for  the 
redemption  of  bonds  is  also  a  deductible  loss.  It  has  been  held  that 
the  corporation  may  deduct  as  a  loss  all  that  it  pays  in  excess  of  wrbat 
it  originally  receives.  For  example,  if  the  ten-year  bonds  of  the  Fidelity 
Corporation  which,  in  our  illustration,  were  issued  at  96,  are  redeemed 


THE  INCOME  AND  PROFITS  TAXES 


65 


after  five  years  at  par,  the  corporation  would  then  have  deducted  only 
one-half  of  the  loss  under  the  prorating  plan  described;  therefore  it  may 
now  deduct  the  other  one-half.  If  the  bonds  are  redeemed  at  102,  the 
loss  which  may  be  then  deducted  is  2  points  (or  $20  on  a  $1,000  bond) 
greater.  Suppose  now  that  the  bonds  were  issued  at  102  and  the  corpora¬ 
tion  included  the  $20  premium  in  its  taxable  income.  It  may  subsequently 
leduct  the  $20  when  it  redeems  the  bonds  at  102.  If,  in'that  case,  the 
whole  amount  received  had  been  treated  as  capital  and  not  as  income 
when  received,  then  there  is  no  loss  when  the  same  amount  of  capital 
is  repaid. 

170.  Capital  Stock  Issued  at  Discount  or  Redeemed  at  Premium.  As 
has  been  pointed  out  (par.  154)  any  discount  upon  the  issue  of  capital 
stock  or  expenses  incurred  in  selling  such  stock  or  raising  the  capital  is 
entirely  a  reduction  of  capital  and  may  not  be  deducted  from  the  income 
of  any  year,  by  prorating  or  otherwise.  Similarly,  the  redemption  of 
capital  stock  at  a  premium  does  not  constitute  a  deductible  loss.  The 
preferred  stock  of  a  corporation  is  in  many  cases  redeemable  at  a 
premium,  say  105.  In  case  such  stock  has  been  issued  at  par,  its  redemp¬ 
tion  would  reduce  the  surplus  of  the  corporation,  but  because  the  trans¬ 
action  is  entirely  a  reduction  of  capital  and  does  not  affect  the  income, 
the  loss  incurred  may  not  be  deducted. 


5.  Depreciation. 

171.  Physical  Exhaustion  of  Property.  The  law  permits  the  deduc¬ 
tion  of  “a  reasonable  allowance  for  the  exhaustion,  wear  and  tear  of 
property  used  in  the  trade  or  business.”  This  deduction  must  be  made 
as  a  separate  item  of  the  Return,  and  must  be  explained  according  to 
the  instruction  on  the  Return  by  showing  separated  for  each  class  of 
property  its  character,  cost  or  value  on  March  1,  1913,  estimated  life, 
depreciation  charged  for  the  taxable  year  and  total  depreciation  charged 
for  all  prior  years.  It  represents  an  actual  physical  loss,  which  can  not 
be  escaped  or  diminished  by  bookkeeping,  so  that  it  is  not  necessary 
that  there  be  any  reserve  fund  created  or  maintained.  Corporations,  how¬ 
ever,  must  charge  depreciation  upon  their  books  or  the  deduction  will 
not  be  allowed.  Although  the  loss  is  actual,  nevertheless  the  measure 
of  it  is  necessarily  a  matter  of  estimate  and  is  governed  by  the  rules 
explained  below. 

172.  Obsolescence.  The  1919  law  expressly  permits  the  deduction 
of  a  reasonable  allowance  for  the  obsolescence  of  property,  wThich  means 
the  decline  in  the  value  of  property  by  reason  of  its  becoming  out 
of  date.  It  is  generally  understood  to  indicate  a  process  which  is 
gradual  and  more  or  less  certain  at  all  times,  rather  than  an  anticipated 
sudden  effect.  It  should  apply  to  all  property  of  which  the  value  is 
known  to  be  disappearing  because  of  progress  in  the  industry,  changes 
in  style  and  social  conditions,  and  other  circumstances  depending  on 
the  mere  passage  of  time  rather  than  on  physical  exhaustion.  The 
allowance  wrill  probably  be  included  in  a  single  deduction  which  covers 
also  the  physical  exhaustion,  but  it  represents  a  distinct  and  different 
loss.  It  implies  an  estimate  of  the  length  of  time  in  which  the  property 


66 


THE  INCOME  AND  PROFITS  TAXES 


will  become  out  of  date,  so  that  it  will  have  to  be  discarded  or  replaced 
with  more  modern  property,  and  an  annual  charge  against  income  to 
provide  for  this  anticipated  loss.  Such  a  charge  involves  a  very  great 
degree  of  pure  guesswork  and  many  practical  difficulties  in  connection 
with  the  administration  of  the  law.  It  has  not  heretofore  been  allowed 
by  the  Income  Tax  Law  and  Regulations,  and  until  the  new  Regulations 
appear  the  requirements  for  computing  and  establishing  the  deduction 
can  not  be  stated.  The  special  deduction  for  Amortization  (par.  179) 
provides  for  the  obsolescence  in  war  industries.  Furthermore,  if  prop¬ 
erty  is  found  to  be  obsolete  and  worthless  before  its  cost  has  been  re¬ 
turned  or  set  aside  by  means  of  the  depreciation  and  obsolescence  allow¬ 
ance,  the  remaining  cost  may  be  at  that  time  deducted  from  the  current 
income,  as  a  loss,  as  explained  at  par.  164. 

173.  Shrinkage  in  Value.  Mere  shrinkage  in  value,  not  the  result 
of  physical  exhaustion  or  gradual  obsolescence,  is  not  depreciation  and 
is  not  deductible  under  this  heading.  For  instance,  stock  and  bonds,  the 
good  will  of  a  business,  or  unimproved  real  estate,  cannot  be  the  basis 
for  any  depreciation  allowance.  -No  allowance  for  the  exhaustion  or 
reduction  of  the  fertility  of  farm  land  has  been  recognized. 

174.  Applies  Only  to  Business  Property.  Depreciation  is  deductible 

only  in  connection  with  property  used  in  the  trade  or  business  and  there¬ 
fore  individuals  are  not  allowed  to  deduct  the  depreciation  sustained 
by  property  for  personal  use,  such  as  a  pleasure  automobile  or  a  dwell¬ 
ing  house.  The  owner  of  property  -which  is  rented  to  others  as  a  source 
of  income  may  deduct  the  depreciation  of  such  property.  Where  the 
dwelling  is  partly  used  for  business,  as  where  a  physician  has  his  office 
in  his  home  or  -where  the  owner  of  an  apartment  building  occupies  part 
and  rents  part,  the  appropriate  portion  of  the  total  depreciation  may 
be  deducted. 

175.  Determination  of  the  Allowance.  The  nature  and  purpose  of 

the  allowance  for  depreciation  is  to  properly  charge  against  and  appro¬ 
priate  from  the  apparent  income,  what  is  really  payment  for  the  exhaus¬ 
tion  or  disappearance  of  capital,  so  that  worn  out  property  may  be 
replaced  without  additional  investment  by  the  owner  ,and  the  original 
investment  may  be  returned  unimpaired  to  the  owner  when  the  busi¬ 
ness  is  liquidated.  It  is  thus  obvious  that  the  depreciation  allowance 
has  been  excessive  where  it  results  in  extinguishing  the  entire  cost  of 
property  which  remains  valuable  and  continues  in  use  in  the  business, 
and  equally  obvious  that  the  allowance  is  deficient  if  the  property  is 
actually  worth  less  before  the  cost  has  been  charged  off  by  the  deprecia¬ 
tion  allowance.  If  the  property  continues  in  use  after  its  cost  has  been 
charged  off  no  further  depreciation  may  then  be  claimed.  If  the  prop¬ 
erty  is  actually  discarded  before  the  end  of  the  estimated  life,  that 
part  of  the  cost  which  exceeds  the  proper  allowance  for  depreciation, 
may  then  be  deducted  as  loss.  In  addition,  the  allowance  deducted  in 
each  year  should  represent  the  amount  of  loss  which  has  accrued  during 
that  year,  so  that  the  net  book  value  will  be  representative  of  the 
actual  value  of  the  property.  If  the  allowance  is  excessive,  the  income 
of  each  year  is  unduly  reduced  and  the  Return  is  incorrect.  If  the  allow¬ 
ance  is  insufficient,  the  profits  of  the  business  are  illusory  rather  than 


THE  INCOME  AND  PROFITS  TAXES 


67 


real  and  the  surplus  which  is  included  in  the  invested  capital  must  be 
reduced  by  deducting  a  proper  allowance  for  the  depreciation  and  obsoles¬ 
cence  which  has  actually  occurred.  Although  property  does  not  wear  out 
to  exactly  the  same  extent  every  year,  the  best  practice  and  the  Regula¬ 
tions  of  the  Treasury  Department  require  that  the  same  allowance  be 
made  in  each  year,  determined  by  dividing  the  original  cost  of  the  prop- 
etry  (or  value  on  March  1,  1913),  less  its  estimated  value  if  any  when 
worn  out  or  discarded,  over  the  estimated  number  of  years  for  which  it 
will  probably  be  of  service.  The  fact  that  no  deduction,  or  insufficient 
deduction,  was  made  in  prior  years  does  not  warrant  a  greater  deduction 
in  any  current  year.  Where  property  was  acquired  prior  to  March 
1,  1913,  its  value  as  of  that  date  may  be  used  as  the  basis  for  the 
deduction,  but  it  will  be  presumed,  in  the  absence  of  proof  to  the  con¬ 
trary,  that  such  value  is  the  original  cost  less  depreciation  up  to  that 
date.  In  making  the  estimate  of  probable  life,  it  is  not  required  that  the 
actual  collapse  of  a  building  or  disintegration  of  a  machine  should  be 
contemplated,  but  that  there  must  be  an  estimate  of  the  number  of  years 
for  which  the  property  will  remain  suitable  for  the  purposes  for  which 
it  was  acquired,  with  proper  allowance  for  the  estimated  salvage  value 
at  the  end  of  that  time.  The  estimate  should  assume  that  the  property 
will  be  maintained  in  good  repair  during  the  period. 

176.  Rates  of  Depreciation.  The  Treasury  Department  has  refused 
to  announce  or  approve  any  fixed  rates  of  depreciation,  properly  holding 
that  the  rate  must  in  each  case  depend  upon  the  circumstances  of  the 
particular  case,  including  not  only  the  nature  of  the  property,  its  age 
and  condition  wdien  acquired,  and  the  character  of  its  use,  but  also  the 
extent  to  which  it  is  maintained.  The  following  rates,  however,  are 
suggestive  of  the  proper  allowance  for  physical  exhaustion,  not 
including  obsolescence,  under  average  conditions;  frame  buildings 
4%- 10%;  brick  buildings,  2%-3%;  brick-and-steel  buildings,  2%;  rein 
forced  concrete  and  stone  buildings,  l%-2%;  automobiles,  motor 
trucks,  and  farm  tractors,  10%-25%;  horses  and  wagons,  15%-25%; 
light  or  rapidly  operating  machinery,  20%-30%;  heavy  machinery, 
5%-10%;  boilers,  steam  piping,  engines,  heating  and  ventilating  sys¬ 
tems,  turbines,  generators,  wire,  motors,  batteries,  mine  and  mill  equip¬ 
ment,  6%-10%;  patterns  and  tools,  20%-25%;  office  furniture  and  books. 
20%.  Where  machinery  is  run  overtime,  the  depreciation  is  greater 
than  where  the  equipment  is  used  only  during  the  regular  working  hours, 
which  illustrates  the  general  rule  that  all  of  the  facts  involved  must  be 
taken  into  consideration. 

177.  Relation  to  Repairs.  The  depreciation  allowance  should  be 
determined  upon  the  assumption  that  the  property  W’ill  be  kept  in  reason¬ 
able  repair.  The  amount  of  repairs  and  replacements  of  course  affects 
the  extent  of  the  physical  exhaustion,  and  it  is  moreover  conceivable 
that  property  may  be  maintained  to  such  an  extent  that  there  is  no 
depreciation.  In  such  a  case  the  cost  of  repair  and  replacement  might 
properly  be  charged  to  expense  and  then  no  deduction  for  the  deprecia¬ 
tion  would  be  allowable  or,  on  the  other  hand,  the  cost  of  new  parts 
might  be  charged  against  the  existing  depreciation  reserve,  in  which 
event  the  usual  allowance  should  be  deducted.  Thus  the  practice  in 


68 


THE  INCOME  AND  PROFITS  TAXES 


charging  repairs  and  replacements  is  one  factor  in  the  reasonable¬ 
ness  of  the  depreciation  charge.  The  proper  purpose  of  the  depreciation 
allowance,  however,  is  to  cover  the  decline  which  occurs  in  spite  of 
the  proper  maintenance  of  property  and  it  therefore  does  not  conflict 
with  the  deduction  of  such  maintenance  as  is  properly  chargeable  to 
expense.  On  the  other  hand,  if  the  exhaustion  of  property  has  been 
the  subject  of  an  allowance  for  depreciation  in  a  previous  year,  the 
expense  for  making  good  such  exhaustion,  even  though  it  might  ordi¬ 
narily  be  considered  current  maintenance,  must  be  charged  against  the 
reserve  or  previous  allowance  for  depreciation  and  cannot  be  deducted 
from  the  current  net  income.  Since  the  theory  of  the  depreciation 
allowance  is  that  at  the  end  of  the  estimated  life  the  owmer  will  have 
no  property  but  wTill  have  its  value  set  aside,  he  is  not  entitled  to 
deduct  from  his  income  the  cost  of  replacing  the  property  for  which 
the  investment  has  already  been  set  aside,  nor  may  he  deduct  any  allovr- 
ance  for  exhaustion  wThich  is  in  fact  made  good  out  of  income.  He  is 
not  entitled  to  end  the  period  of  estimated  life  with  both  the  value 
of  the  property  and  the  property  itself,  without  having  paid  income  tax 
upon  his  gain. 

178.  Depreciation  of  Patents.  It  has  been  held  that  the  disappear¬ 
ing  value  of  a  patent  may  be  accounted  for  by  the  deduction  of  deprecia¬ 
tion.  The  value  on  March  1,  1913,  or  if  subsequently  acquired,  the 
actual  cost,  either  the  price  paid  for  an  assignment  or  the  cost  of  secur¬ 
ing  the  patent  from  the  government,  making  models  and  drawings,  etc., 
should  be  pro-rated  over  the  seventeen  years  of  the  life  of  the  patent 
and  1/17  deducted  in  each  year.  If  it  was  purchased  when  only  part  of 
the  full  term  remained,  the  price  then  paid  should  be  pro-rated  by  the 
purchaser  over  the  number  of  years  of  remaining  life. 

6.  Amortization  of  War  Plants. 

179.  Anticipated  Decline  in  Value  Deductible.  A  special  deduction 
is  provided  for,  in  recognition  of  the  losses  -which  will  be  sustained  by 
reason  of  peace  readjustment  and  the  shrinkage  in  value  of  property 
acquired  at  high  prices  for  war  industry.  It  is  limited  to  buildings, 
machinery,  equipment,  or  other  facilities  wdiich  have  been  constructed  or 
acquired,  on  or  after  April  6,  1917,  for  the  production  of  articles  contrib¬ 
uting  to  the  prosecution  of  the  present  war,  and  to  vessels  constructed 
or  acquired  on  or  after  such  date  for  the  transportation  of  articles  or 
men  contributing  to  the  present  war.  Regulations  to  be  issued  wall 
describe  the  articles  which  will  be  recognized  as  contributing  to  the 
prosecution  of  the  war  and  will  prescribe  the  form  of  proof  which  must 
be  furnished  to  show  that  the  plant  was  used  in  such  production  or 
acquired  for  that  purpose.  The  anticipated  loss  upon  such  property  may 
be  charged  off  from  the  taxable  income  before  it  has  occurred  by 
deducting  an  estimated  amount  from  the  net  income  of  the  taxable 
year  1918  and  subsequent  years.  The  allowance  must  be  based  upon 
the  amount  actually  invested  by  the  taxpayer  after  this  country  entered 
the  war,  wflth  allowance  for  the  estimated  value  of  the  property  under 
peace  conditions  and  the  amount  of  cost  which  will  be  returned  from 


THE  INCOME  AND  PROFITS  TAXES 


6P 


income  through  the  normal  depreciation  charge,  which  is  distinct  from 
and  in  addition  to  the  amortization  allowance.  To  illustrate:  The  New¬ 
ton  Button  Company  in  December,  1917,  invested  $5,000  in  special 
machines  and  additions  to  its  equipment  for  the  purpose  of  making  cer¬ 
tain  machine-gun  parts.  It  is  estimated  that  this  property  will  remain 
in  use  well  into  1919,  but  that  it  must  then  be  either  discarded  or 
remodeled  and  converted  to  other  purposes.  It  is  estimated  that  it 
would  bring  not  more  than  $500  upon  a  sale  at  that  time  but  that  with 
an  additional  investment  of  $2,000  it  could  be  converted  into  machines 
normally  worth  $3,000  to  the  Newton  Button  Company.  The  total  antici¬ 
pated  loss  during  the  two  years  of  use  will  therefore  be  $4,500  if  the 
property  is  sold,  or  $4,000  if  it  can  be  used  by  the  company.  Physical 
depreciation  is  estimated  at  10%  or  $500  in  each  year,  leaving  $3,500 
or  $3,000  to  be  amortized.  The  company  anticipated  a  favorable  out¬ 
look  and  an  available  surplus  for  expansion  in  1919,  which  will  induce 
it  to  retain  the  property,  and  therefore  figures  the  loss  at  the  smaller 
amount,  deducting  $1,500  for  amortization  in  1918  and  also  in  1919. 

180.  Adjustment  After  Actual  Loss  is  Established.  At  any  time 
within  three  years  after  the  conclusion  of  the  peace  treaties  or  procla¬ 
mation  by  the  President,  the  Commissioner  of  Internal  Revenue  may  of 
his  own  initiative  have  the  property  appraised  or  receive  other  evi¬ 
dence  of  the  actual  shrinkage  in  value,  to  determine  whether  the  allow¬ 
ance  was  correct.  If  not,  the  Returns  for  the  years  affected  shall  be 
revised  and  the  taxes  redetermined,  any  excess  being  refunded  and  any 
deficiency  being  collected.  During  the  same  period,  the  adjustment  must 
be  made  upon  request  of  the  taxpayer.  Thus  the  Newton  Button  Com¬ 
pany,  in  the  illustrative  case  above,  may  find  itself  unable  to  retain 
the  property  and  may  sell  it  for  $500  in  1920.  Instead  of  charging  off 
the  remaining  $400  as  a  loss  in  1920,  when  the  rate  of  tax  is  lower,  the 
company  may  apply  for  an  adjustment  of  its  1918  and  1919  returns  and 
receive  credit  for  this  loss  against  the  income  to  which  the  high  Profits 
Tax  applied.  Or,  on  the  assumption  that  the  company  retained  the 
property,  the  commissioner  may  in  1922  have  it  appraised  as  of  the  end 
of  the  war.  If  it  should  then  be  found  that  its  fair  value  was  $2,500 
instead  of  $1,000,  at  which  it  was  estimated,  the  additional  $1,500  will 
be  added  to  the  1918  and  1919  income  of  the  company  and  the  appropri¬ 
ate  Income  and  Profits  Tax  will  be  assessed.  If  the  loss  has  been  esti¬ 
mated  fairly  and  in  good  faith  no  penalties  will  be  imposed,  but  any 
attempt  to  evade  the  tax  will  be  punishable  by  all  the  fines  and  penal¬ 
ties  for  false  Returns. 

7.  Depletion  of  Natural  Resources. 

181.  Allowance  for  Mines,  Oil  and  Gas  Wells,  Timber,  Etc.  In 
view  of  the  sp>ecial  character  of  the  income  realized  by  the  conversion 
of  natural  resources,  the  law  contains  special  provisions  for  deducting 
from  the  gross  income  an  allowance  for  returning  the  investment  which 
is  exhausted  by  the  operations.  In  such  a  case  the  entire  price  realized 
for  the  product  is  not  income  but  represents  in  part  the  capital  originally 
invested  in  the  property  in  its  natural  state  and  only  in  part  the  pro- 


70 


THE  INCOME  AND  PROFITS  TAXES 


ductive  operation.  It  is  first  necessary  to  estimate  the  quantity  of 
mineral  or  standing  timber  as  of  March  1,  1913,  or  when  subsequently 
acquired.  The  value  on  March  1,  1913,  of  property  then  owned  or 
the  exact  cost  of  property  subsequently  acquired  must  then  be  divided 
over  the  total  quantity,  thus  fixing  the  amount  of  capital  invested  in 
each  unit.  Cost  may  include  cost  of  development  not  otherwise  de¬ 
ducted,  but  must  not  include  the  cost  of  physical  property  upon  which 
depreciation  may  be  claimed  nor  the  cost  of  any  other  property  except 
the  natural  resources.  The  law  further  provides  that  where  mines  or 
oil  wells  or  gas  wells  were  discovered  by  the  taxpayer  after  March  1, 
1913,  the  depletion  allowance  may  be  based  upon  the  fair  value  of  the 
property  within  thirty  days  after  the  discovery  of  the  natural  deposit, 
rather  than  upon  the  cost  to  the  taxpayer,  provided  that  such  value  is 
materially  disproportionate  to  the  cost.  The  amount  thus  fixed  may 
be  charged  for  each  unit  removed  during  the  taxable  year.  Neither 
the  unit  charge  nor  the  total  investment  can  be  changed  after  once 
being  fixed  but  must  be  adhered  to  in  all  future  years.  The  amount 
of  the  investment  and  the  amount  charged  in  each  year  must  be  carried 
by  the  taxpayer  in  appropriate  ledger  accounts  and  when  the  original 
investment  has  been  extinguished,  no  further  deduction  will  be  allowed 
but  the  entire  price  received  will  be  income.  In  the  case  of  oil  wells 
or  gas  wells,  if  the  quantity  can  not  be  determined  with  any  degree  of 
certainty,  the  allowance  may  be  computed  on  the  basis  of  reduction  in 
flow  and  production,  reducing  the  investment  by  the  same  percentage  as 
the  annual  production  is  reduced.  Amounts  invested  by  lessees  in  addi¬ 
tion  to  royalties  and  other  deductible  items  may  be  extinguished  upon 
the  same  plan. 

8.  Contribution  to  Charities. 

182.  Certain  Donations  Deductible.  Contributions  or  gifts,  made 
within  the  year  covered  by  the  Return  to  certain  classes  of  charitable 
organizations,  may  be  deducted  by  an  individual  to  an  amount  not  in 
excess  of  15%  of  his  net  income  as  computed  without  the  benefit  of  this 
deduction.  This  deduction  is  not  allowed  to  corporations.  The  members 
of  partnerships  in  computing  their  net  income,  may  individually  take 
credit  for  their  proportion  of  such  gifts  made  by  the  firm.  The  con¬ 
tributions  may  be  deducted,  only  if  verified  under  rules  and  regulations 
which  will  be  prescribed,  and  only  if  made  to  corporations  or  associa¬ 
tions  organized  and  operated  exclusively  for  religious,  charitable,  scien¬ 
tific,  or  educational  purposes,  or  to  societies  for  the  prevention  of  cruelty 
to  children  and  animals,  no  part  of  the  net  income  of  which  inures  to 
the  benefit  of  any  private  stockholder  or  individual,  or  to  the  special 
fund  authorized  by  Congress  for  Vocational  Rehabilitation.  Gifts 
made  to  individuals  are  not  deductible.  Donations  to  an  organized 
church  for  any  activity  in  furtherance  of  religion  are  deductible.  In 
computing  the  net  income  of  an  estate  or  trust,  there  is  allowed,  instead 
of  this  deduction,  the  amount  which,  pursuant  to  the  will  or  deed  creat¬ 
ing  the  trust,  is  during  the  taxable  year  paid  to  or  permanently  set  aside 
for  (1)  the  United  States,  a  state,  or  a  political  subdivision,  or  (2)  a 
corporation  or  association  such  as  above  described. 


THE  INCOME  AND  PROFITS  TAXES 


71 


PART  4.  RETURNS  AND  PAYMENT  OF  TAX. 

183.  Time  for  Filing  Returns.  Returns  of  individuals  and  corpora¬ 
tions  must  be  filed  on  or  before  March  15  of  each  year,  or  the  fifteenth 
day  of  the  third  month  following  the  close  of  the  fiscal  year  where  made 
on  the  basis  of  a  fiscal  year.  If  the  last  day  for  filing  the  Return  falls 
upon  a  Sunday  or  legal  holiday,  the  Return  is  in  time  if  it  is  filed  on  the 
next  day.  In  case  of  sickness  or  absence  of  the  person  who  is  required 
to  execute  the  Return,  but  not  for  other  causes,  the  collector  of  internal 
revenue  may  grant  one  extension  of  not  to  exceed  thirty  days,  upon  writ¬ 
ten  application  therefor,  made  before  the  Return  is  due.  The  Com¬ 
missioner  may  allow  an  extension  of  not  more  than  six  months  whenever 
in  his  judgment  good  cause  exists,  and  for  an  unlimited  time  in  case  of 
taxpayers  who  are  abroad.  If  the  Return  is  not  filed  in  time,  the  tax¬ 
payer  is  subject  to  a  penalty  of  $1,000  and,  unless  it  is  shown  that  the 
delay  was  due  to  a  reasonable  cause  and  not  wilful  neglect  or  mere  over¬ 
sight,  to  a  further  penalty  of  25%  of  the  amount  of  the  tax.  The  con¬ 
sequent  delay  in  paying  the  first  or  subsequent  installments  is  also 
subject  to  penalty. 

184.  Filing  by  Mail.  The  Return  may  be  mailed  to  the  collector, 
and  will  be  considered  as  on  time  if  it  is  placed  in  the  mails,  properly 
addressed  and  postage  paid,  early  enough  so  that  it  would,  in  due  course 
of  mail,  reach  the  collector  within  the  required  time.  The  Return  is 
not  filed  in  time  merely  because  it  is  deposited  in  the  mails  on  the  day 
the  office  of  the  collector  of  internal  revenue  for  the  district  in  which 
that  it  should  be  filed. 

185.  Place  of  Filing.  The  Return  of  an  individual  should  be  filed 
where  such  person  resides  or  has  his  principal  place  of  business.  The 
Return  of  a  corporation  should  be  filed  in  the  office  of  the  collector  of 
internal  revenue  for  the  district  in  which  is  located  the  principal  office 
of  the  corporation,  where  are  kept  its  books  of  account  and  other  data 
from  which  the  Return  is  prepared. 

186.  Return  Made  by  Agent.  When  the  person  required  to  make 
a  Return  is  unable  to  do  so  because  of  illness,  minority,  insanity,  absence, 
or  non-residence,  it  must  be  done  by  an  agent  having  sufficient  knowl¬ 
edge  of  the  affairs  and  property  of  the  taxpayer  to  enable  him  to  make 
a  complete  and  true  Return.  A  person  acting  under  a  powTer  of  attorney 
in  the  management  of  property  is  not  obligated  to  make  a  Return,  nor 
will  a  Return  by  any  agent,  in  the  absence  or  inability  on  the  part  of 
the  principal,  discharge  the  legal  liability  of  the  principal. 

187.  Understatement  and  False  Returns.  The  collector  may  require 
any  taxpayer  to  produce  evidence  in  support  of  his  Return  and  to  sub¬ 
mit  to  examination  wdth  reference  to  ail  items  in  it,  and  may  increase 
amounts  which  he  finds  to  be  understated.  An  appeal  may  be  taken  to 
the  Commissioner  of  Internal  Revenue  if  the  taxpayer  objects  to  such 
an  increase.  The  Treasury  Department  also  employs  a  large  number  of 
investigating  agents  with  authority  to  examine  the  books  of  taxpayers 
to  discover  errors,  omissions,  and  evasions  in  Returns,  and  may  assess 
any  additional  taxes.  Except  where  the  Return  was  false  or  fraudulent, 
such  assessment  must  be  made  within  five  years  from  the  date  when  the 


72 


THE  INCOME  AND  PROFITS  TAXES 


return  was  due  or  was  made.  If  the  facts  given  on  the  Return  show  a 
tax  liability  greater  than  that  reported,  the  additional  amount  may  be 
assessed  without  change  in  the  Return.  In  every  case  wffiere  a  Return 
contains  a  false  or  fraudulent  understatement  made  with  intent  to 
evade  the  tax,  or  is  wilfully  false  or  fraudulent,  a  penalty  is  imposed 
of  50%  of  the  amount  by  which  the  tax  is  understated,  or  the  same 
percentage  of  the  entire  tax  in  any  case  of  false  or  fraudulent  Return 
other  than  understatement.  In  addition,  any  wilful  attempt  to  defeat 
or  evade  the  tax  is  punishable  by  fine  of  not  more  than  $10,000  or  impris¬ 
onment  for  not  more  than  one  year,  or  both.  Where  the  understatement 
is  due  to  negligence,  even  though  without  intent  to  defraud,  the  penalty 
is  5%  of  the  deficiency  in  tax,  plus  interest  at  1%  per  month  on  the 
deficiency  in  each  installment  from  the  time  when  it  was  payable. 
If  the  Return  is  made  in  good  faith  and  an  understatement  occurs 
without  any  fault  of  the  taxpayer,  there  is  no  penalty  but  the  tax  will 
be  increased  to  the  proper  amount.  If  a  further  assessment  is  made 
because  of  an  incorrect  Return,  the  taxpayer  is  bound  by  such  assess¬ 
ment  unless  it  is  proved  that  the  Return  was  not  wilfully  false  or  fraudu¬ 
lent  and  did  not  contain  any  wilful  understatement  or  undervaluation. 

188.  Rejected  and  Amended  Returns.  Frequently  collectors  refuse 
to  accept  Returns  which  do  not  conform  to  their  ideas  of  computation  of 
the  tax,  but  this  exceeds  their  authority.  If  the  Return  is  completely 
filled  out  and  properly  executed  the  taxpayer  may  demand  that  it  be 
filed.  If  the  collector  considers  it  incorrect,  he  may  report  the  facts 
for  assessment  according  to  his  opinion.  The  investigating  agents  also 
prepare  amended  R-eturns  where  they  find  additional  tax  to  be  due,  and 
generally  urge  the  taxpayers  to  sign  them.  Executing  such  a  Return 
may  preclude  any  objection  to  the  contents  or  to  the  assessment  based 
upon  it.  The  law  imposes  upon  every  person,  whether  subject  to  tax  or 
not,  the  duty  of  truly  stating  the  facts,  and  authorizes  the  Treasury 
Department  to  prescribe  the  form  and  manner  of  statement.  All  the 
information  required  by  the  Regulations  or  by  the  directions  on  the 
Returns  must  be  given,  but  the  taxpayer  cannot  be  compelled  to  swear 
to  statements  which  he  does  not  believe  are  true.  He  should  therefore 
make  his  Return  according  to  his  own  information  and  his  own  con¬ 
science,  acting  upon  the  best  advice  available,  and  should  refuse  to 
alter  it  until  convinced  that  he  is  wrong.  Where  an  error  in  a  Return 
is  discovered  after  it  has  been  filed  permission  to  file  an  Amended 
Return  should  at  once  be  requested.  The  Amended  Return  may  accom¬ 
pany  the  request.  If  additional  tax  liability  appears,  an  affidavit  should 
also  be  filed,  stating  fully  the  cause  for  the  difference  and  claiming  the 
abatement  of  penalties  for  delay  and  false  return. 

189.  Time  of  Payment.  The  Income  and  Profits  Taxes  are  due  in 
four  equal  installments  on  March  15,  June  15,  September  15,  and  Decem¬ 
ber  15.  Except  for  the  first  installment,  wThich  is  due  without  any  bill 
or  notice,  payment  need  not  be  made  until  notice  of  assessment  has  been 
given.  Payment  of  the  whole  tax  may  be  made  on  or  before  the  due 
date  of  the  Return,  but  no  discount  is  allowed.  Where  the  Return  is 
filed  on  a  fiscal  year  basis,  the  installments  are  due  when  the  Return  is 
due  and  in  the  third,  sixth,  and  ninth  months  thereafter.  An  extension 


THE  INCOME  AND  PROFITS  TAXES 


73 


of  time  for  filing  the  Return  postpones  the  time  of  payment  of  the  first 
installment,  but  not  the  subsequent  installments  unless  the  Commis 
sioner  (not  the  collector)  provides  otherwise.  Where  the  extension  was 
granted  at  the  request  of  the  taxpayer,  interest  is  charged  on  the  first 
installment  at  the  rate  of  Yic/o  per  month  from  the  original  due  date,  but 
no  interest  is  added  if  the  time  is  extended  by  a  general  order.  It  will 
be  noted  that  the  due  date  of  payment  relates  to  the  time  when  the 
Return  is  due,  not  when  it  is  filed.  If  any  installment  is  not  paid  when 
it  is  due,  the  whole  amount  of  the  tax  becomes  due  and  payable  upon 
notice  and  demand  by  the  collector.  The  tax  may  also  be  declared  due 
and  payable  in  advance  of  the  regular  dates  because  of  the  taxpayer’s 
design  to  take  some  action  prejudicing  the  collection  of  the  tax.  If  too 
small  an  amount  has  been  paid  upon  any  installment  because  of  an 
understatement  in  the  Return,  the  deficiency  is  due  upon  notice  and 
demand.  Any  amount  paid  in  excess  of  actual  liability  will  be  credited 
against  future  installments  or  refunded. 

190.  Means  of  Payment.  Payment  must  be  made  in  cash  or  bank 
check  or  draft  which  will  not  involve  cost  of  collection.  Collectors  will 
receive  uncertified  checks  and  the  tax  will  be  considered  paid  as  of 
the  date  the  check  is  received,  provided  that  it  is  not  later  dishonored. 
If  a  check  is  not  paid  upon  presentation,  the  liability  for  the  tax  and 
all  penalties  is  revived. 

191.  Penalties  for  Delinquency  in  Payment.  The  penalty  for  delay 
in  paying  any  installment  is  5%  of  the  amount,  plus  interest  at  1%  per 
month  from  the  date  fixed  by  the  notice  and  demand  from  the  collector. 
On  the  first  installment,  the  penalty  and  interest  accrue  from  the  date 
when  the  Return  is  due  and  the  instructions  on  the  Return  constitute 
the  only  notice  and  demand  which  is  required.  The  penalties  do  not 
attach  against  the  estate  of  a  deceased,  insane,  or  insolvent  person. 

192.  Assessment,  Collection,  and  Refund.  Taxes,  interest,  and 
penalties  other  than  the  specific  fines,  may  be  collected  with¬ 
out  court  action,  by  seizure  and  sale  of  any  property  of  the 
delinquent.  The  amount  due  may  also  be  collected  by  court 
action.  No  proceeding  to  collect  taxes  may  be  begun  aftfcr 
five  years  from  the  date  the  Return  was  due  or  was  filed, 
except  where  the  Return  was  false  or  fraudulent  with  intent  to  evade 
the  tax.  The  collector  gives  notice  of  assessment  and  demands  pay¬ 
ment,  fixing  the  time  when  he  will  proceed  to  enforce  collection.  The 
notice  may  be  mailed  and  it  is  then  presumed  that  it  was  duly  received, 
although  the  taxpayer  may  offer  proof  to  the  contrary.  No  court  action 
to  prevent  the  assessment  or  collection  of  any  tax  may  be  maintained, 
but  the  taxpayer  may  appeal  to  the  Collector  of  Internal  Revenue  by  a 
claim  (Form  47)  for  the  abatement  of  any  assessment  made  by  the  Col¬ 
lector.  The  filing  of  a  bona  fide  claim  for  abatement  prevents  the 
imposition  of  the  5%  penalty,  but  interest  on  the  unpaid  amount  runs 
at  Y2%  per  month  from  the  original  due  date.  Any  amount  not  believed 
to  be  due  should  be  paid  under  protest,  that  is  a  written  protest  should 
be  delivered  with  the  payment,  stating  that  the  tax  is  paid  under  duress 
and  not  voluntarily  and  denying  the  legality  of  the  assessment  and  col 
lection,  and  a  receipt  marked  “Paid  Under  Protest”  should  be  requested. 


74 


THE  INCOME  AND  PROFITS  TAXES 


Any  amount  paid  contrary  to  law  may  be  recovered  by  a  claim  for 
refund  (Form  46).  A  suit  to  recover  taxes  paid  can  also  be  brought 
against  the  United  States  or  the  collector,  but  only  after  a  claim 
for  refund  has  been  duly  filed  and  within  two  years  after  such  claim  for 
refund  has  been  rejected  or  has  been  on  file  for  six  months  without 
decision.  Claims  for  refund  must  be  filed  within  two  years  from  the 
date  payment  was  made,  or  within  five  years  if  the  overpayment  appears 
from  the  face  of  the  Return.  Amounts  found  to  be  due  may  be  applied 
against  similar  taxes  due  by  the  same  taxpayer  for  a  different  period. 

PART  5.  INFORMATION  AND  PAYMENT  AT  SOURCE. 

193.  Returns  of  Information.  Every  person,  partnership,  and  cor¬ 
poration  is  required  to  file  Returns  of  Information  at  the  Source,  sub¬ 
ject  to  penalties  similar  to  those  imposed  for  delinquency  in  filing  the 
Income  Tax  and  Profits  Tax  Returns.  The  Returns  of  Information  must 
be  made  on  the  calendar  year  basis  and  not  for  the  fiscal  year,  and  are 
filed  at  Washington  by  mail,  not  with  the  local  collector. 

194.  Payments  of  $1,000  per  year.  At  the  time  fixed  by  the  Regula¬ 
tions  in  each  year,  without  further  notice  or  demand,  there  is  due  a 
Return  (Form  1096)  showing  the  amount  of  all  payments  made  during 
the  year  of  fixed  and  determinable  gains,  profits  and  income  (such  as 
salaries,  interest,  or  rent),  amounting  to  $1,000  or  more  for  the  year, 
and  a  separate  report  (Form  1099)  showing  the  name  and  address  of 
each  recipient.  The  requirement  is  not  limited  to  periodical  payments, 
but  a  single  payment  of  $1,500  as  fees  to  a  lawyer  or  commissions  to  a 
broker  would  be  included.  Payments  which  are  not  purely  income  to  the 
recipient,  for  example  payment  for  merchandise,  storage,  or  telephone 
service,  are  not  included. 

195.  Corporation  Interest  and  Dividends.  Upon  notice  from  the 
Treasury  Department,  a  corporation  may  be  required  to  file  the  Return 
of  Information  as  to  the  interest  paid  upon  its  bonds  or  similar  obliga¬ 
tions,  without  regard  to  the  amount  of  the  particular  payments.  (See 
par.  199  as  to  Returns  for  interest  on  tax-free  bonds.)  A  similar  Return 
as  to  dividends  paid  must  be  filed,  but  only  after  notice  from  the  Treasury 
Department. 

196.  Brokers.  Brokers  may  be  required  to  make  Returns  showing 
the  names  of  all  customers,  details  as  to  the  profits  and  losses  of  each, 
and  such  other  information  as  the  Regulations  may  require. 

197.  Foreign  Interest  and  Dividends.  A  Return  may  be  required  of 
every  person  in  the  business  of  collecting  coupons,  checks,  or  bills  of 
exchange  not  payable  in  the  United  States,  in  payment  of  interest  on 
bonds  of  foreign  countries  and  foreign  corporations,  or  dividends  on 
stock  of  foreign  corporations,  and  all  such  payments,  no  matter  how 
small  the  amount,  must  then  be  reported.  If  such  interest  or  dividends 
are  payable  in  this  country  by  a  resident  fiscal  agent  the  requirment 
does  not  apply.  Persons  undertaking  the  collection  of  such  foreign  items 
as  a  matter  of  business  or  profit  must  be  licensed  by  the  Treasury 
Department. 


THE  INCOME  AND  PROFITS  TAXES 


75 


198.  Payment  at  the  Source.  In  order  to  assist  in  the  collection 
of  the  tax,  payment  is  required  by  the  person  paying  the  income,  rather 
than  the  one  receiving  it,  in  the  case  of  interest  on  tax  free  bonds  and 
payments  to  nonresident  aliens  (see  par.  20)  and  foreign  corporations 
(see  par.  37)  of  fixed  and  determinable  annual  or  periodical  income  (but 
not  including  interest  on  tax  free  bonds  or  dividends  of  domestic  corpora¬ 
tions)  without  regard  to  the  amount  of  the  payment.  On  or  before  March 
1  of  each  calendar  year,  with  no  provision  for  fiscal  years,  persons  making 
the  specified  payments  must  make  Returns  and  by  June  15  must  pay 
the  tax  to  the  government.  The  lawT  permits  the  amount  so  paid  to 
be  deducted  and  withheld  from  the  payment  made  to  the  recipient,  except 
where  there  is  a  contractual  obligation  to  the  contrary,  as  with  tax 
free  bonds. 

199.  Interest  on  Tax  Free  Bonds.  Whenever  bonds,  mortgages,  or 
similar  obligations  of  a  corporation  contain  a  contract  or  provision  by 
which  the  corporation  agrees  to  pay  the  interest  upon  such  obligation 
without  deduction  for  any  tax  which  the  corporation  may  be  required 
or  permitted  to  pay  thereon  or  to  retain  therefrom  under  the  Federal 
Income  Tax  Law,  or  by  which  the  corporation  agrees  to  pay,  on  behalf 
of  the  owner  of  the  bonds,  any  portion  of  any  federal  income  tax 
imposed  upon  the  interest,  or  to  reimburse  the  owner  therefor,  the 
corporation  is  required  to  pay  to  the  government  a  tax  of  2  per  cent 
of  the  interest.  As  there  are  many  different  forms  of  “tax  free 
covenants,”  it  must  be  determined  in  each  case  whether  the  language 
used  covers  the  federal  income  tax.  These  provisions  apply  only  to 
long  term  or  funded  obligations  which  may  be  classed  as  securities, 
and  not  to  promissory  notes,  scrip,  or  ordinary  commercial  paper. 
Securities  issued  by  syndicates,  partnerships,  or  individuals,  subject 
to  tax  free  covenants,  are  not  included  although  they  may  in  all  other 
respects  resemble  the  obligations  of  corporations,  as  to  wrhich  payment 
at  the  source  is  required.  The  tax  must  be  paid  without  regard  to  the 
amount  of  the  particular  payments,  but  only  w’hen  the  interest  is  paid 
to  an  individual  (or  foreign  corporation)  and  not  when  paid 
to  a  partnership  or  domestic  corporation.  The  tax  need  not  be  paid 
if  the  owner  files  a  notice  before  February  1  claiming  exemption  or 
credits  covering  the  interest  received  during  the  previous  year.  This 
claim  (Form  1001)  is  usually  filed  at  the  time  the  interest  is  collected. 
Where  ownership  is  not  knowm,  the  tax  should  be  paid. 

200.  Certificates  of  Ownership.  Any  person  making  payments  of 
income  for  which  he  is  required  to  pay  a  tax  at  the  source  or  to  give 
information  at  the  source  is  entitled  to  demand  the  necessary  information 
from  the  recipient  of  the  income,  and  certificates  in  appropriate  form 
may  be  secured  for  this  purpose  from  the  collector. 

PART  6.  ILLUSTRATIVE  CASES 
1.  Individual  Income  Tax. 

201.  Dry  Goods  Store.  Abel  Wise  conducted  a  dry  goods  store.  In 
December  1917,  he  inventoried  his  stock  in  trade  at  $21,000,  which  wras 


76 


THE  INCOME  AND  PKOFITS  TAXES 


the  cost.  During  1918  he  purchased  $63,000  worth  of  goods  and  sold 
a  total  of  $81,000  in  retail  trade.  In  December,  1918,  his  goods  inven¬ 
toried  $27,000  at  cost  price  and  would  be  more  at  market  value,  although 
he  had  no  more  on  hand  than  at  the  time  of  the  previous  inventory. 
During  the  year  his  family  has  used  $247  worth  of  goods  taken  from 
the  stock.  Answer:  (See  paragraphs  78,  79,  133,  139,  140).  Abel  Wise 
will  add  the  inventory  of  the  stock  on  hand  at  the  first  of  the  year 
to  the  purchases,  making  $84,000,  and  will  deduct  the  inventory  taken 
in  December,  1918,  giving  a  net  cost  of  $57,000.  This  amount  deducted 
from  the  sales  of  $81,000  leaves  $24,000  as  gross  income.  The  value 
of  the  goods  consumed  must  be  added.  In  addition,  Wise  will  deduct 
from  this  his  general  expenses,  losses,  depreciation,  etc.,  to  determine 
his  net  income. 

202.  Landlord.  Christopher  Hansen  owned  an  apartment  house  con¬ 
taining  three  apartments,  all  of  which  were  heated  by  one  furnace 
in  the  basement.  Hansen  lived  in  the  first  floor  apartment  with  his 
family  and  rented  the  two  upper  apartments  for  $45  a  month  each, 
furnishing  the  heat,  light  for  the  halls,  running  water,  and  a  janitor. 
How  should  the  apartment  figure  in  Hansen’s  income  schedule?  Answer: 
(see  pars.  79,  127,  133,  144,  174) — Hansen  must  determine  how  much  of 
the  cost  of  the  heat,  light,  running  water  and  janitor  service  is  attribut¬ 
able  to  his  own  apartment,  and  the  balance  of  such  cost  he  may  deduct 
from  his  gross  income  as  expense.  The  same  proportion  of  the  deprecia¬ 
tion  of  the  building  should  also  be  deducted.  The  entire  amount  received 
as  rent,  but  not  the  rental  value  of  his  own  apartment,  must  be  included 
in  the  gross  income. 

203.  Professional  Income.  George  Lee  is  a  physician  supporting  a 
family  consisting  of  his  wife,  two  children  under  age  and  two  over 
eighteen  years  of  age.  He  owns  an  automobile  which  he  uses  both  in 
his  professional  work  and  for  pleasure,  fully  three-fourths  of  its  use 
being  for  business.  During  1918  the  cost  of  running  the  automobile 
included  the  salary  of  his  chauffeur,  $1,456;  gasoline,  repairs,  and  other 
expense,  $1,638.25;  insurance  $53.85.  The  depreciation  of  the  automobile 
is  estimated  at  $150,  one-tenth  of  its  original  cost.  During  the  year  the 
doctor  spent  $437  for  club  and  lodge  dues,  entertainment,  etc.,  which 
he  charges  to  an  account  called  “good  will  promotion.”  To  the  same 
account  he  charges  $200  which  he  donated  to  the  local  charity  organiza¬ 
tion  and  $17  which  were  his  expenses  on  a  short  trip  to  give  a  free 
lecture  for  a  local  Y.  M.  C.  A.  He  spent  $460  during  the  year  attending 
medical  conventions,  $36  for  medical  journals  and  dues  for  medical 
societies,  and  $300  for  books  and  instruments  of  a  permanent  value. 
His  office  and  traveling  expenses  were  $14,948.40  for  the  year.  His 
professional  fees  amounted  to  $30,653  for  the  year  and  in  addition  he 
received  $419.30  as  compensation  for  a  short  period  which  he  served 
in  the  army  before  the  armistice.  He  spent  $600  for  uniforms,  equip¬ 
ment,  etc.,  when  in  the  army.  Doctor  Lee  also  owned  a  house  which 
he  rented  during  the  year  for  $1,356.  The  expenses  for  repairs,  insurance, 
etc.,  on  this  house  were  $16.06  and  the  depreciation  is  estimated  at  $200. 
The  taxes  upon  this  rented  property  and  upon  the  home  of  Doctor  Lee 
amounted  to  $509.19.  The  Doctor’s  wife  received  $95,  as  interest  on  a 


THE  INCOME  AND  PROFITS  TAXES 


77 


mortgage.  How  will  Doctor  Lee  report  his  net  income?  Answer:  (See 
pars.  78,  133,  143,  144,  158,  182) — The  gross  income  from  services  will 
include  the  professional  fees  amounting  to  $30,653,  but  not  the  compensa¬ 
tion  received  in  the  army.  From  this  will  be  deducted  the  office  and 
traveling  expenses,  three-fourths  of  the  automobile  expense  and  deprecia¬ 
tion,  expenses  of  attending  conventions  and  cost  of  medical  journals 
and  societies,  a  total  of  $17,917.97,  making  his  net  income  from  services 
$12,735.03.  The  club  dues,  etc.  and  the  cost  of  army  equipment  are 
personal  expenses.  The  cost  of  books  and  implements  is  not  deductible, 
but  the  Doctor  should  carry  a  property  account  and  charge  off  a  deprecia¬ 
tion  and  obsolescence  allowance  upon  such  property.  The  net  income 
from  the  rented  property  is  $1,139.94.  The  interest  on  Mrs.  Lee’s 
mortgage  will  be  included  on  the  Doctor’s  Return.  The  taxes  will  be 
deducted,  as  will  the  $200  charitable  donation.  The  $17  is  not  deductible 
because  it  was  an  expense  and  not  a  donation,  although  incurred  in  a 
charitable  enterprise.  The  total  net  income  was  therefore  $13,180.78, 
which  will  be  taxed  as  follows:  Deduct  wife’s  income,  leaving  $13,085.78, 
upon  which  the  normal  tax,  deducting  the  $2,400  exemption,  is  $1,042.29, 
the  surtax  is  $244.29,  and  the  total  tax  is  $1,286.58.  Adding  the  $5.70 
normal  tax  on  the  income  of  Mrs  Lee,  the  total  tax  shown  by  the  Return 
is  $1,292.28. 

204.  Farmer.  Henry  Woodhouse,  a  farmer,  had  the  following  transac¬ 
tions  among  others  during  1918:  In  the  month  of  May  lie  purchased  for 
$400  a  breeding  sow  with  a  litter  of  five  young  pigs.  He  sold  the  five  pigs 
in  December  for  a  total  sum  of  $200  cash  and  kept  the  sow.  He  also 
bought  some  cattle  for  feeding  and  resale,  which  be  still  had  on  December 
31.  How  must  he  figure  these  items  in  his  Return?  Answer:  (See  para¬ 
graphs  94,  142).  Woodhouse  must  determine  the  cost  of  the  sow  as  apart 
from  the  pigs  at  the  time  of  purchase.  The  cost  of  the  sow  must  be 
included  in  the  permanent  investment  account  and  not  as  a  deduction 
from  gross  income.  The  profit  on  the  pigs  must  be  included  in  the  gross 
income.  The  expense  of  keeping  and  feeding  the  pigs  may  be  added  to 
the  original  cost  in  determining  profit,  or  they  may  be  omitted  here, 
and  included  as  part  of  the  general  expense  of  the  farm  on  the  Income 
Tax  Return.  The  cost  of  the  cattle  is  not  deductible,  but  when  they  are 
sold  the  profit  or  loss  will  be  then  determined. 

205.  Inadequate  Accounts.  Walter  Bower,  supporting  a  wife  and 
mother,  is  in  the  brick  manufacturing  business.  His  bookkeeping  system 
is  very  crude,  and  he  estimates  his  profits  by  the  annual  increase  in 
his  bank  balance,  and  investments.  On  January  1,  1918,  he  estimated  that 
his  plant  was  worth  $16,000,  -with  brick  on  hand  worth  $5,000.  He  had 
$1,000  in  the  bank,  and  $4,000  drawing  interest  at  7%  in  a  building  and 
loan  association.  On  December  31,  1918,  his  plant  had  depreciated  some¬ 
what  in  value;  his  brick  on  hand  was  worth  $3,500;  his  bank  balance  was 
$1,000;  his  building  and  loan  association  deposits  were  $6,000;  he  had  a 
touring  automobile  purchased  for  $800  in  May  of  the  same  year.  He 
estimated  his  personal  and  home  expenses  at  $200  a  month.  How  shall 
he  determine  his  income  tax?  Answer:  (See  paragraphs  59,  85,  101,  141, 
175).  Since  Bower  has  not  kept  an  account,  his  income  must  be  estimated. 
He  has  spent  during  the  year,  $2,400  for  living  expenses,  $800  for  the 


78 


THE  INCOME  AND  PROFITS  TAXES 


automobile,  and  $2,000  added  to  his  building  and  loan  investment,  or 
$5,200,  which  he  must  have  received.  On  the  other  hand,  his  stock  of 
brick  is  reduced  $1,500,  so  that,  as  his  bank  balance  is  the  same,  his 
gross  income  was  probably  $3,700,  and  should  be  so  returned.  He  is 
entitled  to  deduct  from  this  gross  income  the  depreciation  of  his  brick 
plant,  which  would  be,  at  3%,  $480,  leaving  his  net  income  $3,220. 
Deducting  his  exemption  of  $2,000  (his  mother  being  neither  mentally 
nor  physically  defective)  he  must  pay  6%  on  $1,220,  or  $73.20. 

206.  Securities.  Elam  Stratford,  retired,  living  with  his  wife,  has 
an  income  of  $8,000  a  year,  derived  as  follows:  $1,000  from  Pennsylvania 
Railroad  Stock,  $1,000  from  Middle  East  Utilities  Corporation  6 % 
gold  bonds  (guaranteed  tax  free),  $800  from  Anglo-American  Steamship 
Company  bonds  (not  tax  free),  $200  from  Yucatan  Gum  Corporation 
stock  (a  Mexican  corporation  doing  no  business  in  the  United  States 
and  not  subject  to  the  Income  Tax  Laws),  $2,000  from  a  stock  farm 
which  is  under  the  management  of  a  foreman,  and  $3,000  a  year  from  a 
partnership  engaged  in  the  leather  business,  from  which  he  retired,  but 
in  which  he  retains  a  direct  interest.  How  must  he  figure  his  income  tax? 
Answer:  (See  paragraphs  94,  114,  116,  135,  142,  199).  Mr.  Stratford’s 
Return  would  be  as  follows:  from  business,  etc.,  $2,000  (from  the  stock 
farm);  partnership  profit,  $3,000;  interest  on  tax  free  bonds,  $1,000; 
other  interest  $800;  dividends  from  foreign  corporations,  subject  to 
normal  tax,  $200  (from  the  gum  corporation);  dividends  from  domestic 
corporations,  $1,000  (from  the  Pennsylvania  Railroad  stock).  The 
totals  will  be:  Gross  Income  and  Net  Income,  $8,000;  dividends,  $1,000; 
exemption  $2,000,  and  income  subject  to  normal  tax,  $5,000.  Normal  tax, 
$360;  credit  amount  of  normal  tax  paid  at  source,  $20;  balance  of  normal 
tax  due,  $340,  surtax  on  $8,000,  $50.  Total  Incomo  Tax,  $390. 

207.  Exempt  Income.  Howard  Johnson,  unmarried,  has  an  income 
of  $60.00  a  month  as  a  law  clerk.  He  owns  United  States  Steel  Stock, 
netting  him  an  income  of  $500  a  year.  On  May  1,  1918,  he  received 
$10,000  as  a  legacy  from  his  mother’s  estate,  all  of  which  he  invested 
in  United  States  Liberty  Bonds,  netting  him  3 Y>%  interest,  payable 
semi-annually,  June  15  and  December  15.  How  .shall  Johnson  make 
his  return  for  the  year  1918?  Answer:  (See  pars.  63,  72,  78,  116).  The 
gift  from  his  mother’s  estate  is  not  taxable  and  need  not  appear  any¬ 
where  in  his  Income  Tax  Return.  His  gross  income  includes  salary 
$720,  and  dividends  $500,  total  $1,200,  so  he  must  file  a  Return.  The  in¬ 
terest  on  the  Liberty  Bonds  is  not  shown  on  the  Return  and  the  dividends 
are  exempt  from  the  Normal  Tax.  The  personal  exemption  of  $1,000 
leaves  no  taxable  income. 

2.  Corporation  Income  and  Profits  Tax. 

208.  Return  for  Part  of  Year.  The  Kramer  Crane  Company  has 
always  made  its  Income  Tax  Returns  on  the  calendar  year  basis,  but  its 
books  are  kept  on  the  basis  of  a  fiscal  year  ending  on  Februry  28. 
How  should  it  make  its  Return  for  1918?  Answer:  (See  pars.  29,  58). 
The  Return  which  it  must  file  on  or  before  March  15,  1919,  will  cover 
only  the  two  months  of  January  and  February,  1918,  and  will  show 


THE  INCOME  AND  PROFITS  TAXES 


79 


the  actual  income  of  those  two  months,  the  invested  capital  at  that 
time,  including  surplus  earned  prior  to  January  1,  1918.  The  Profits 
Tax  and  Income  Tax  credits  will  be  reduced  to  1/6  of  the  specific 
exemptions,  1/6  of  the  prewar  income,  and  1/6  of  the  allowance  of 
8%  of  the  invested  capital.  On  or  before  May  15,  1919,  it  must  file 
Returns  covering  the  twelve  months  ending  on  February'  28,  1919.  Upon 
this  Return  the  tax  will  be  the  sum  of  (a)  five-sixths  of  the  tax  com¬ 
puted  at  the  1918  rates  and  (b)  one-sixth  of  the  tax  computed  at  the 
1919  rates,  using  the  entire  net  income  and  entire  credits  for  both  com¬ 
putations. 

209.  Loss  on  Property  Discarded.  The  Lenaire  Company  erected  a 
brick  factory  building  in  January,  1915,  at  a  cost  of  $10,000,  and 
installed  equipment  and  machinery  costing  $5,000.  In  making  its  Re¬ 
turns  of  income  for  the  years  1915,  1916,  and  1917,  the  company  made 
no  deduction  for  the  depreciation  of  the  building,  but  deducted  5%  of 
the  cost  of  the  machinery  as  depreciation  in  the  1917  Return.  In  Janu¬ 
ary,  1918,  the  company  erected  a  new  and  enlarged  plant  upon  the  same 
site,  selling  the  materials  in  the  old  building  to  a  wrecking  company  for 
$800.  Improvements  in  processes  and  machinery  made  it  advisable  to 
dispose  of  all  the  old  equipment,  which  was  sold  for  $1,500,  and  entirely 
new  equipment  was  installed.  How  will  this  affect  the  income  for  1918  ? 
Answer:  (See  pars.  122,  172,  175,  176).  The  cost  of  the  old  building  may 
be  carried  as  one  item  in  the  cost  of  the  new’  building  or  it  may  be 
charged  off.  The  building  has  depreciated  probably  at  the  rate  of  2% 
each  year,  or  a  total  of  $600.  The  actual  loss,  above  the  salvage,  is  there¬ 
fore  $8,600,  which  may  be  deducted  from  the  1918  income  as  a  loss.  The 
machinery  has  probably  depreciated  10%  to  15%  in  each  year.  Taking 
the  15%  figure  as  the  fact,  there  has  been  an  actual  depreciation  of 
$2,250  (of  which  only  $250  has  been  charged  in  the  books),  leaving  the 
residual  value  over  the  salvage,  $1,250,  which  may  be  deducted  as  a 
loss  in  1918.  The  depreciation  used  to  determine  the  residual  value 
should  be  charged  upon  the  books  of  the  company,  and  the  company 
should  ask  leave  to  file  amended  Returns  for  the  years  1915,  1916,  and 
1917,  claiming  the  benefit  of  such  depreciation  which  was  not  claimed  at 
the  time.  If  the  amended  returns  are  accepted  they  should  be  accom¬ 
panied  by  a  claim,  on  Form  46,  for  refund  of  the  tax  paid  on  income  in 
excess  of  the  actual  income. 

210.  Timber  Company.  The  Western  Timber  Corporation  purchased 
standing  timber  in  the  year  1910  which  on  March  1,  1913,  had  a  well 
established  market  value  as  follows:  Oak,  $9  per  thousand  feet;  pine, 
$8  per  thousand  feet,  and  mixed  timber,  $6  per  thousand  feet.  The  cor¬ 
poration  owned  its  own  saw  mill  and  in  1918  cut  and  sold  one  million 
feet  of  lumber  of  each  of  the  above  grades.  How  shall  the  corporation 
make  out  its  Return.  Answer:  (See  par.  179.)  The  value  on  March 
1,  1913,  of  the  timber  sold  will  be  deducted  by  a  depletion  allowance;  the 
expenses  of  manufacturing  and  selling  are  to  be  deducted  in  the  general 
deduction  for  expense. 

211.  Reorganization.  The  P.  &  A.  Corporation  had  been  unable  to 
pay  any  dividends  to  its  stockholders  for  several  years  and  in  1917 
failed  to  earn  the  interest  on  its  bonds.  The  following  scheme  of  reor- 


80 


THE  INCOME  AND  PROFITS  TAXES 


ganization  was  proposed  by  a  bondholders ’  committee  and  was  adopted 
by  the  consent  of  all  parties.  The  company  had  outstanding  stock 
amounting  to  $500,000,  par  value,  $100  a  share;  first  mortgage  bonds 
amounting  to  $300,000  in  denominations  of  $1,000  each,  and  second  lien 
debentures  amounting  to  $200,000,  also  denominations  of  $1,000.  The 
plan  was  to  exchange  all  of  the  outstanding  stock  and  bonds  for  a  new 
issue  of  stock  in  the  same  amount  as  formerly,  and  to  sell  new  bonds 
for  cash  to  be  used  in  restoring  the  business.  The  first  mortgage  bonds 
were  exchangeable  for  an  equal  amount  in  par  value  of  the  new  stock, 
the  debentures  for  one-half  of  their  par  value,  and  the  old  stock  for  one- 
fifth  of  its  par  value,  of  five  shares  for  one  new  one.  All  of  the  securi¬ 
ties  were  exchanged  on  this  basis.  Walter  Harmon  owned  ten  of  the 
bonds  for  which  he  received  100  shares  of  the  new  stock,  ten  of  the  de¬ 
bentures  for  which  he  received  50  shares,  and  500  shares  of  the  old  stock 
for  which  he  received  100  shares  of  the  new  stock.  He  also  bought 
ten  of  the  new  bonds  at  96.  How  shall  the  transaction  be  reported  in 
the  income  tax  Returns  of  Harmon,  and  of  the  P.  &  A.  Corporation? 
Answer:  (See  pars.  110,  131,  169).  As  to  Harmon,  the  transaction  may 
be  considered  as  closed  and  the  par  value  of  the  securities  taken  as  the 
basis  of  profit  and  loss.  As  to  the  first  mortgage  bonds  there  is  no 
loss  unless  Harmon  bought  them  at  a  premium;  if  the  price  he  paid  for 
them,  or  their  value  on  March  1,  1913,  was  anything  less  than  par,  he 
need  not  report  a  profit  on  his  return  but  may  hold  the  new  stock  at 
the  same  cost.  On  the  debentures  there  has  been  a  loss  of  $5,000  as  a 
debt  ascertained  to  be  worthless.  On  the  shares  of  stbck  there  has  been 
a  profit  or  loss  equal  to  the  difference  between  $20  per  share  and  the 
value  as  of  March  1,  1913,  or,  if  purchased  since  that  date,  the  cost. 
The  bonds  purchased  at  96  are  an  investment  upon  which  there  is  no 
profit  or  loss  until  they  are  sold  or  paid  off.  The  corporation  has  been 
relieved  of  $500,000  of  indebtedness,  but  this  is  not  income.  The  debt 
was  in  part  paid  by  giving  each  creditor  a  shareholder’s  interest  in  the 
assets  of  the  corporation;  the  balance  was,  if  anything,  a  gift.  Neither 
the  cancellation  of  some  of  its  capital  stock  liability  nor  the  creation  of 
other  capital  stock  was  gain  or  loss  to  the  corporation.  The  issue  of 
the  bonds  at  96  involved  a  loss  of  4%  of  the  amount  issued,  to  be 
pro-rated  and  deducted  in  annual  installments  during  the  life  of  the 
bonds. 

212.  Corporation  Promotion.  The  Hamilton  Equipment  Corporation 
was  organized  in  January,  1918,  to  exploit  a  newly  patented  device  for 
making  iron  castings.  The  company  was  capitalized  at  $100,000.  In 
order  to  make  the  stock  fully  paid  and  non-assessable,  and  at  the  same 
time  available  for  sale  at  less  than  par  without  a  stock  liability,  an 
arrangement  was  made  with  the  patent  owner  whereby  his  device  was 
assigned  to  the  company  for  all  of  the  stock  of  the  corporation  and 
whereby  the  inventor  turned  back  into  the  treasury  of  the  company  49% 
of  the  stock  as  “  treasury  stock,”  to  be  sold  for  the  benefit  of  the  com¬ 
pany  in  creating  working  capital.  How  must  this  transaction  be  sched¬ 
uled  in  the  Return?  Answer:  (See  pars.  43,  47,  63,  108,  109).  The 
stock  is  a  gift  to  the  corporation,  and  therefore  neither  its  value  nor  the 
proceeds  upon  its  sale  need  be  included  in  the  Income  Return.  If  there 


THE  INCOME  AND  PROFITS  TAXES 


81 


is  an  increase  in  its  value,  so  that  it  is  sold  for  more  than  its  value  when 
received,  such  increase  should  be  accounted  for  as  profit.  The  invested 
capital  will  be  the  amount  actually  realized  by  the  sale  of  the  treasury 
stock  plus  an  amount  not  in  excess  of  (a)  the  actual  value  of  the 
patent  when  acquired  or  (b)  25%  of  the  stock  outstanding  at  the  first 
of  the  year,  not  including  treasury  stock,  or  (c)  $51,000,  the  par  value 
of  the  stock  issued  for  the  patent. 

213.  Buying  Leasehold.  The  Fidelity  Shoe  Stores  issued  $50,000 

of  its  capital  stock  to  pay  for  a  leasehold  having  twenty-five  years  to 
run.  How  shall  this  be  scheduled  in  the  Returns?  Answer:  (See  pars. 
48,  109,  144).  4%  of  the  actual  value  of  the  stock  when  issued  may 

be  charged  off  the  books  each  year  as  an  expense  of  doing  business.  The 
leasehold  is  tangible  property  which  may  be  included  in  the  invested 
capital  at  its  actual  value  when  acquired. 

214.  Invested  Capital  of  Consolidation.  In  1901,  the  Stewart  Shirt 
Company  was  organized  and  took  over  the  assets  of  a  dozen  going  con¬ 
cerns,  issuing  therefor  $250,000  of  capital  stock.  The  assets  consisted 
of  various  plant  structures,  equipment,  real  estate,  patents,  and  good 
will.  At  the  time  of  the  transaction  all  of  these  items  were  entered  in 
a  lump  sum  and  no  attempt  was  made  to  indicate  the  specific  amounts 
of  stock  issued  for  the  respective  kinds  of  property.  It  is  shown  that  at 
that  time  the  tangible  property  was  worth  $100,000,  the  patents  $20,000, 
and  the  good  will  not  less  than  $70,000.  How  is  the  invested  capital  to 
be  computed?  Answer:  (See  pars.  47,  49).  It  will  be  presumed  that 
$100,000  of  the  stock  was  issued  for  the  tangible  property,  and  that 
$150,000  was  issued  for  the  good  will,  which  can  be  included  only  at  not 
more  than  25%  of  the  outstanding  capital  stock,  or  $62,500.  The  in¬ 
vested  capital  will  therefore  be  $162,500,  plus  any  undivided  profits. 

215.  Comparative  Profits  Tax.  For  very  many  years  the  Marc  & 
Wright  Co.  conducted  a  cannery  which  had  been  very  profitable  and 
which  had  been  several  times  enlarged.  The  company  had  kept  very  in¬ 
adequate  books  and  had  no  record  of  the  cost  of  the  plant  and  equip¬ 
ment.  The  net  income  for  the  year  1918  is  $52,000,  and  the  Return 
claims  the  benefit  of  the  assessment  at  the  comparative  rate.  The  Com¬ 
missioner  of  Internal  Revenue  determines  that  the  average  Profits  Tax 
of  representative  corporations,  in  the  cannery  business,  under  similar 
circumstances,  is  41%  of  the  net  income.  The  Commissioner  finds  that  he 
is  unable  to  determine  the  invested  capital.  Howr  will  the  Profits 
Tax  be  computed?  Answer:  (See  pars.  27-28).  The  Return  will  show 
a  Profits  Tax  of  50%  of  the  net  income,  or  $26,000,  and  an  Income  Tax 
of  $3,120.  The  Marc  &  Wright  Co.  will  pay  the  first  installment  of 
$7,280,  and  subsequent  installments  which  come  due  before  the  decision 
on  the  claim.  The  Commissioner,  through  the  collector,  will  notify  the 
company  of  his  decision  and  of  the  assessment  of  the  Profits  Tax  at 
41%.  of  the  net  income,  or  $21,320.  The  Income  Tax  is  $3,681.60  in 
addition.  Since  each  installment  is  reduced  by  $1,029.60,  this  amount 
of  each  payment  will  be  credited  toward  any  installments  remaining 
unpaid  or  will  be  refunded. 

216.  Losses  and  Invested  Capital.  The  Greenhill  Ice  Company  was 
incorporated  for  $70,000,  all  of  which  was  paid  in  with  cash  and  invested 


82 


THE  INCOME  AND  PROFITS  TAXES 


in  a  plant  for  making  ice,  which  was  built  by  the  company  in  1911. 
The  books  of  the  company  made  no  allowance  for  depreciation  and 
showed  an  accumulated  loss  from  operations  of  $15,000  on  January  1, 
1917.  During  1917  it  earned  $16,000.  What  is  the  invested  capital  for 
1918?  Answer:  (See  pars.  44,  46,  50).  The  amount  of  the  loss  and 
also  the  amount  of  depreciation  actually  sustained,  probably  2%  per 
year  on  cost  of  building  and  10%  per  year  on  cost  of  machinery,  must 
be  deducted  from  any  undivided  profits  which  are  to  be  included  in 
the  invested  capital,  and  therefore  the  $16,000  earned  in  1917  may  not 
be  included.  The  losses  need  not  be  deducted  from  the  $70,000  capital, 
since  the  stockholders  have  never  received  any  part  of  their  original  in¬ 
vestment  and  have  full  credit  for  the  $70,000  which  they  still  have  in 
the  business. 

217.  Appreciation  and  Invested  Capital.  The  real  estate  which  was 
purchased  by  the  Greenhill  Ice  Company  for  $15,000  has  more  than 
doubled  in  value,  according  to  an  appraisal  made  in  1916,  and  it  is 
carried  on  the  books  at  $30,000,  the  $15,000  of  increased  value  having 
been  added  to  offset  the  accumulated  losses  of  $15,000.  How  will  this 
affect  the  invested  capital?  Answer:  (See  pars.  44,  46,  50).  Invested 
capital  must  not  include  any  part  of  the  increased  valuation,  but  $15,000 
must  be  deducted  from  the  book  value  of  assets,  and  from  any  book 
surplus  (but  not  from  the  original  investment). 


TITLE  2.  CAPITAL  STOCK  TAX. 

218.  Nature  and  Application.  A  special  excise  tax  known  as  the 
Capital  Stock  Tax  is  levied  upon  carrying  on  or  doing  business  in  the 
corporate  form  within  the  United  States.  The  tax  is  paid  in  advance 
for  the  government’s  fiscal  year,  that  is,  from  July  1  to  June  30,  but 
it  is  measured  by  the  fair  value  of  the  capital  stock  during  the  year 
preceding  that  for  which  the  tax  is  paid.  The  tax  is  at  the  rate  of  $1 
for  each  $1,000  of  such  value  above  the  exemption  of  $5,000.  This 
rate  applies  for  the  first  time  for  the  period  beginning  July  1,  1918,  and 
will  be  assessed  upon  the  Return  made  during  1918  under  the  previous 
law,  although  such  Return  shows  a  higher  exemption  and  a  lower  tax 
rate.  The  tax  applies  to  every  corporation,  joint  stock  company  or  asso¬ 
ciation,  mutual  insurance  company,  limited  partnership,  “Massachusetts 
Trust,”  or  other  association  of  participating  or  shareholding  members, 
except  that  corporations  which  are  exempt  from  Income  Tax  (par.  33) 
are  likewise  exempt  from  this  tax. 

219.  Corporations  Formed  or  Dissolved  During  the  Year.  The  law 

expressly  provides  that  the  tax  shall  not  be  imposed  upon  any  corpora¬ 
tion  which  was  not  engaged  in  business  during  the  preceding  taxable 
year.  Therefore,  a  corporation  organized  or  first  engaging  in  business 
after  July  1,  1918,  is  not  subject  to  any  tax  for  the  fiscal  year  1918-1919, 
even  though  it  exercises  the  corporate  privilege  during  that  year. 
A  corporation  which  was  doing  business  during  the  preceding 
year  for  even  one  day  is  subject  to  tax.  It  is  held  that 
any  corporation  which  succeeds  another  corporation  pursuant  to 


MISCELLANEOUS  WAR  TAXES 


an  agreement,  is  subject  to  the  tax.  On  the  other  haml  t lie  tax  is 
imposed  only  upon  corporations  which  carry  on  business  during  the 
taxable  year,  so  that  a  corporation  dissolved  on  or  before  June  30, 
1010,  is  not  subject  to  the  tax  for  the  tiseai  year  1919*20.  If  a  eorpora- 
:ion  is  dissolved  ten  days  after  the  beginning  of  the  taxable  year,  it 
must  make  a  Return  and  pay  the  full  rate  of  tax  without  any  refund 
because  of  the  dissolution. 

220.  Inactive  Corporations.  Since  the  tax  is  imposed  only  upon 
‘‘carrying  on  or  doing  business,  ”  a  corporation  may  be  exempt  because 
it  was  not  engaged  in  business  during  the  taxable  year  or  the  pre¬ 
ceding  year,  even  though  it  may  have  been  in  existence  during  both 
years.  The  following  are  typical  eases  of  corporations  not  subject  to  tax 
for  this  reason:  (1)  A  corporation  in  the  hands  of  a  receiver  and  not 
doing  business  as  a  corporation;  (2)  a  corporation  in  the  process  of 
dissolution  and  liquidation  at  the  beginning  of  the  taxable  year;  (3)  a 
corporation  which  has  entirely  abandoned  its  business;  (4)  a  holding 
company,  which  performs  no  activities  other  than  the  ownership  of 
stock  of  subsidiaries,  the  collection  of  income  therefrom,  and  the  dis¬ 
tribution  of  such  income  in  dividends;  (5)  a  corporation  which  merely 
holds  title  to  property  subject  to  a  long  term  lease  or  otherwise  out  of 
its  control,  and  which  receives  the  income  from  such  property  and  dis¬ 
tributes  the  same  as  dividends. 

221.  The  Return.  Every  corporation  must  make  a  Return  to  be 
filed  in  July  of  each  year,  subject  to  penalties  similar  to  those  explained 
in  connection  with  the  Income  Tax  Return. 

222.  Determination  of  Fair  Value.  The  tax  is  based  upon  the  fair 
average  value  of  the  capital  stock  for  the  preceding  year  ending  June  30. 
This  value  is  an  entirely  different  matter  from  the  par  value  of  the 
stock  or  the  amount  of  the  invested  capital.  It  is  to  be  estimated 
by  the  officers  of  the  corporation,  their  estimate  being  supported  by  a 
showing  of  the  book  value,  the  market  value,  and  the  earning  value, 
which  appears  on  the  Return  in  three  statements  designated  as  Exhibits 
A,  B,  and  C.  Every  corporation  must  fill  out  all  of  these  exhibits  or 
state  why  the  required  data  is  not  available.  The  fair  value  upon  which 
the  tax  is  based  will  be  that  reflected  bv  the  exhibit  showing  the 
greatest  value,  except  that  the  corporation  may  submit  a  statement 

showing  whv  the  tax  should  be  assessed  on  some  other  basis. 

• 

223.  Book  Value  Determined  by  Exhibit  A.  Exhibit  A  is  a  con¬ 
densed  balance  sheet  as  of  the  end  of  the  fiscal  year  of  the  corporation, 
showing  all  assets  and  liabilities  according  to  the  books  of  the  company, 
and  also  at  the  fair  actual  value  wherever  this  differs  from  the  book  value. 
The  difference  between  t lie  fair  value  and  the  books  of  the  company 
must  be  explained  in  sufficient  detail  to  enable  the  Commissioner  of  In¬ 
ternal  Revenue  to  determine  if  the  adjustments  are  proper  and  accept¬ 
able.  The  books  of  the  company  need  not  be  adjusted  to  take  up  the 
differences  shown.  The  capital,  surplus,  and  undivided  profits,  as  shown 
by  the  balance  sheet,  is,  of  course,  the  book  value  of  the  capital  stock, 
and  since  opportunity  is  given  for  adjustment,  will  represent  the  judg- 


84 


MISCELLANEOUS  WAR  TAXES 


ment  of  the  officers  as  to  the  actual  value.  No  provision  seems  'to  be 
made  on  the  Return  for  finding  the  average  of  such  book  value  for  the 
year,  which  is  the  required  value  according  to  the  law. 

224.  Market  Value  Determined  Under  Exhibit  B.  Exhibit  B  rep 
resents  the  market  price  of  the  stock.  If  the  stock  is  listed  Exhibit  B 
should  show  the  mean  of  the  highest  and  lowest  bid  price  for  each 
month  and  the  average  of  these  figures  will  be  the  average  for  the  year. 
The  taxpayer  may  attach  a  schedule  showing  the  highest  and  lowest  bid 
price  for  each  day  rather  than  for  each  month.  If  the  stock  is  not 
listed,  Exhibit  B  should  show  the  prices  obtained  upon  any  sales  made, 
when  such  prices  are  knowui  to  or  determinable  by  the  officers  making 
the  Return.  In  reporting  such  sales,  a  statement  must  be  attached 
showdng  the  number  of  shares  involved  and  the  existing  conditions. 
Sales  under  special  conditions  influencing  prices  will  not  be  considered 
representative  of  fair  value  and  should  not  be  given  on  the  Return. 

225.  Earning  Value  Determined  Under  Exhibit  C.  Exhibit  C  shows 

the  value  of  the  stock  determined  by  capitalizing  the  earning  capacity. 

The  Exhibit  shows  the  income  for  the  preceding  five  years  as  reported 

for  the  Income  Tax  and  such  deductions  and  additions  as  are  fairlv 

%/ 

required  to  obtain  the  actual  income  realized  by  the  company.  A  com¬ 
prehensive  analysis  of  any  amounts  reported  as  deductions  or  additions 
should  be  attached  to  the  Return.  The  Return  does  not  suggest  the  rate 
to  be  used  in  capitalizing  the  average  income,  but  states  that  the  officers 
making  the  Return  will  use  1 1  such  percentage  as  from  their  special 
familiarity  with  the  business  they  know  representative  enterprises  in 
their  line  in  their  locality  must  earn  in  order  to  maintain  their  stock  at 
par. M  Thus,  if  an  18%  return  is  necessary  to  hold  the  value  of  the 
stock  at  par,  this  Exhibit  will  estimate  the  fair  value  by  showing 
100/18  of  the  average  earnings.  If  the  company  has  actually  earned 
27%  on  the  capital  stock,  the  capitalized  value  will  be  $150  per  share. 


MISCELLANEOUS  WAR  TAXES 


sr» 


TITLE  III.  MISCELLANEOUS  WAR  TAXES 

1.  Transportation  and  Communication. 

22 6.  In  effect  April  1,  1919. 

227.  Rates.  Based  on  amount  paid  for  service.  Freight,  3 %. 
Express,  J  cent  on  each  20  cents  or  fraction.  Passengers,  8%  (except 
fares  not  over  42  cents  and  commutation  or  season  tickets  for  trips 
of  less  than  30  miles).  Seats,  berths,  staterooms,  8%.  Oil  by  pipe  line, 
8 %.  Telegraph,  telephone  cable,  or  radio  dispatch,  message,  or  conversa¬ 
tion,  (a)  5  cents  if  charge  is  15  cents  to  50  cents,  (b)  10  cents  if  charge 
is  more  than  50  cents.  Leased  wire  or  talking  circuit  special  service 
(except  for  public  press  or  common  carrier),  10%.  Services  for 
federal  or  state  governments  exempt.  Transportation  includes  incidental 
services,  storage,  demurrage,  etc.  Not  limited  to  common  carriers. 

2.  Insurance. 

In  effect  April  1,  1919. 

228.  Rates.  Life  insurance — (1)  industrial  plan  policies,  not  over 
$500  (may  cover  in  addition  health  and  accident  insurance),  20%  of 
lirst  monthly  premium,  or  40%  of  first  weekly  premium;  (2)  other 
policies,  8  cents  per  each  $100  or  fraction  of  face  of  policy;  (3)  group 
life  insurance,  not  less  than  25  lives  of  person  with  single  employer, 
for  benefit  of  persons  other  than  employer,  4  cents  per  $100  of  aggregate 
face  amount.  Marine,  inland,  and  fire  insurance,  1  cent  on  each  $1 
or  fraction  of  premium.  All  other  insurance  for  loss,  damage,  or  liability 
(excluding  guaranty  and  fidelity  insurance,  but  including  health,  accident, 
burglary,  employers 1  liability,  and  casualty  insurance) — (1)  industrial 
jdan  policies,  20%  of  first  monthly  or  40%  of  first  weekly  premium; 
(2)  other  policies,  1  cent  per  $1  or  fraction  of  premium. 

3.  Excise  Taxes. 

229.  In  effect:  (1)  Tax  on  sales  at  wholesale,  day  after  the  President 
signs  the  Act.  (2)  Tax  on  sales  at  retail — perfumes,  etc.,  May  1,  1919; 
jewelry,  etc.,  April  1,  1919;  sculpture,  etc.,  day  after  President  signs 

the  Act. 

230.  Apply:  (1)  Wholesale  Sales.  On  selling  price  received  by 
manufacturer,  producer  or  importer,  except  that  tax  is  based  upon  cus¬ 
tomary  wholesale  price  in  the  case  of  retail  sale  by  a  manufacturer, 
producer,  or  importer  who  customarily  sells  at  both  retail  and  wholesale. 
(2)  Retail  Sales.  On  price  received  by  a  dealer  upon  a  sale  to  the 
consumer  or  user. 

231.  Rates:  (1)  Wholesale  Sales.  Automobile  trucks  and  auto¬ 
mobile  wagons,  3%.  Other  automobiles  and  motorcycles,  5%.  Automobile 
accessories  (except  when  sold  to  automobile  manufacturers),  5%.  Pianos, 
organs  (other  than  pipe  organs)  piano  players,  graphophones,  phono¬ 
graphs,  talking  machines,  music  boxes  and  records  therefor,  5%.  Sport¬ 
ing  goods  and  games  (except  childrens  toys  and  games),  10%.  Chewing 
Gum,  3%.  Cameras,  weighing  not  more  than  100  pounds,  10%.  Photo 
graphic  films  and  plates  (other  than  moving  picture  films),  5%.  Candy, 
5%.  Fire  arms,  shells  and  cartridges  (except  those  sold  for  the  use  of 


86 


MISCELLANEOUS  WAR  TAXES 


certain  governments),  and  hunting  and  bowie.  knives,  10%.  Dirk  knives, 
daggers,  sword  games,  stiletto,  and  brass  and  metallic  knuckles,  100%. 
Electric  fans  (portable,  5%).  Thermos  and  thermostatic  bottles  or  con¬ 
tainers,  5%.  Cigar  or* cigarette  holders  and  pipes,  composed  wholly  or  in 
part  of  meerschaum  or  amber,  humidors  and  smoking  stands,  10%.  Auto¬ 
matic  slot-device  vending  machines,  5%,  and  weighing  machines,  .10%, 
sold  or  put  into  operation  for  profit  by  the  manufacturer;  liveries  and 
livery  boots  and  hats,  hunting  and  shooting  garments,  and  riding  habits, 
10%;.  Articles  made  of  fur  on  the  hide  or  pelt,  or  articles  of  which  any 
such  fur  is  the  component  material  of  chief  value,  10%.  Yachts  and 
motor  boats,  not  designed  for  trade,  fishing  or  national  defense,  and 
pleasure  boats  and  canoes  if  sold  for  more  than  $15,  10%.  Toilet  soaps 
and  toilet  soap  powders,  3%.  (2)  Retail  Sales.  Jewelry,  watches  and 

clocks,  opera  glasses,  etc.  5%.  Perfumes  and  preparations  for  toilet 
purposes,  and  pills  and  proprietary  medicines,  1  cent  on  each  25  cents 
or  fraction  (may  be  made  payable  by  stamp).  Sculpture,  paintings,  art 
porcelains  and  bronzes  sold  by  any  person  other  than  the  artist,  10%> 
(except  upon  sales  to  public  art  museums  or  educational  institutions). 
(3)  Luxury  Taxes.  A  tax  of  10%  on  the  amount  by  which  the  retail 
price  of  certain  specified  articles,  chiefly  wearing  apparel,  exceeds  the 
price  stated  in  the  law.  Not  given  here  because  of  announcements  that 
these  taxes  will  be  repealed  before  they  become  effective  on  Mav 
1,  1919. 

4.  Admissions. 

232.  Tax:  1  cent  for  each  10  cents  or  fraction  paid  for  admission 
to  any  place  (except  cabarets).  Payable  by  person  paying  for  admission. 

233.  Carbarets.  If  admission  charge  is  wholly  or  in  part  included  in 
price  paid  for  refreshment,  service,  or  merchandise,  20%;  of  amount  paid 
will  be  deemed  to  be  the  admission  charge,  and  will  be  taxed  l1/^  cent 
on  each  10  cents  or  fraction.  Effective  April  1,  1919. 

234.  Tickets  Sold  at  Advanced  Price.  (1)  By  proprietors  or  em¬ 
ployees,  50%  of  regular  or  established  price.  (2)  By  other  persons, 
at  places  other  than  ticket  office  (a)  5%  of  excess  if  not  more  than 
50  cents,  (b)  50%  of  excess  if  more  than  50  cents.  $100  fine  for  selling 
ticket  not  conspicuously  and  indelibly  marked  with  price  for  which 
sold  and  name  of  vendor  if  not  sold  at  ticket  office.  Effective  April 
1,  1919. 

235.  Exemptions.  Admission  without  charge  of  (a)  persons  in 
military  or  naval  forces  of  the  United  States  when  in  uniform,  (b)  chil¬ 
dren  under  twelve  years  of  age,  (c)  municipal  officers  on  official  business, 
(d)  employees.  Where  proceeds  inure  exclusively  to  the  benefit  of  (a) 
persons  in  military  or  naval  forces  of  the  United  States  (b)  religious, 
educational  or  charitable  institution,  societies  or  organizations,  (c) 
societies  for  the  provention  of  cruelty  to  children  or  animals,  (d) 
symphony  orchestra  organizations,  and  agricultural  fairs*  none  of  the 
profits  of  which  are  distributed  to  members. 

TJllPC 

In  effect  April  1,  1919. 

236.  Tax.  10%;  of  dues  or  membership  fees,  where  dues  of  an 
active  resident  annual  member  are  in  excess  of  $10.00  per  year.  10% 


MISCELLANEOUS  WAR  TAXES 


S7 


on  initiation  fees  where  either  such  fees  or  annual  dues  exceed  $10.00. 
Life  members  j  ay  annually  the  tax  upon  the  annual  dues  paid  by  other 
members,  but  the  fee  for  the  life  membership  is  not  taxed. 

237.  Applies  only  to  dues  or  fees  of  social,  athletic,  or  sporting  club 
or  organization,  not  including  fraternal  societies  operating  under  the 
lodge  system. 

6.  Federal  Estate  Tax. 

238.  Application.  To  the  transfer  of  property  at  death.  Based  upon 
entire  taxable  estate,  without  regard  to  the  amount  of  the  distributive 
shares  or  relationship  of  the  beneficiaries.  Whole  estate  of  decedents 
who  were  residents  of  the  United  States;  nonresident  decedent’s  estate 
situated  in  this  country.  Executor,  including  any  person  taking  posses¬ 
sion  of  the  decedent’s  property,  must  make  a  Return  if  the  gross 
estate  is  over  $50,000. 

239.  Rates:  The  “1917  Rates,,  apply  to  estates  of  persons  dying 
after  October  3,  1917,  and  before  the  passage  of  the  1919  law.  The 
“1919  Rates’’  apply  to  estates  of  persons  dying  after  the  day  the 
President  signs  the  new  law: 


Taxable  j 

Estate 

1927  Rates 

1919  Rates 

$50,000  is 

exempt. 

.  1% 

Next  $ 

50,000 . 

.  2%....... 

4  4 

100,000 . 

.  4% . 

.  2% 

4  4 

100,000 . 

.  6% . 

.  3% 

4  4 

200,000 . 

.  8% . 

.  4% 

i  4 

300,000 . 

. 10% . 

.  6% 

4  4 

250,000 . 

. 10% . •. . 

.  8% 

i  « 

500,000 . 

. 12% . 

. 10% 

4  4 

500,000 . 

. 12% . 

. 12% 

« < 

1,000,000 . 

. 14% . 

. 14% 

4  4 

1 ,000,000 . 

. 16% . 

. 16% 

4  4 

1,000,000 . 

. 18% . 

. 18% 

4  4 

3,000,000 . 

. 20% . 

. 20% 

4  4 

2,000,000 . 

. 22% . 

. 22% 

Exceeding 

10,050,000 . 

. 25% . 

. 25% 

240.  Exemptions.  Estate  of  )  erson  dying  while  serving  in  military 
or  naval  forces  of  the  United  States  in  the  present  war,  or  from  injuries 
received  or  disease  contracted  while  in  such  service.  Property  identified 
as  a  share  in  the  estate  of  another  person  who  died  within  the  preceding 
five  years  and  whose  estate  was  subject  to  the  federal  estate  tax. 
Gifts  to  the  United  States,  a  state,  or  a  local  government  for  public 
purposes,  to  charitable  corporations,  or  to  trustees  for  charitable  purposes 
(effective  December  31,  1917).'  Funeral  expenses,  administration  expenses, 
claims,  losses,  support  of  dependents  during  settlement.  Property  held  in 
life  interest. 

241.  Taxable  Estate.  Includes  value,  at  time  of  death,  of:  decedent’s 
interest  in  property  subject  to  charges  against  estate;  dower,  curtesy, 
or  similar  interest  of  surviving  spouse;  property  transferred  in  con¬ 
templation  of  death,  presumptively  including  any  material  part  of 
decedent ’s  property  disposed  of  without  money  consideration  within  two 
years  prior  to  death;  entire  amount  of  property  jointly  held  with 


88 


MISCELLANEOUS  WAR  TAXES 


another  except  as  proof  is  made  of  the  interest  of  other  owners;  property 
passing  by  general  power  of  appointment,  by  will  or  in  contemplation  of 
death;  insurance  on  policies  taken  out  by  decedent  upon  his  own  life, 
payable  to  his  estate  and  the  excess  over  $40,000  payable  to  other 
beneficiaries. 

7.  Special  Taxes. 

242.  The  following  annual  excise  taxes  are  levied  upon  the  carry¬ 
ing  on  of  certain  kinds  of  business.  Returns  must  be  made  by  July  1, 
of  each  year,  or  upon  commencing  business.  Effective  January  1,  1919, 
except  as  noted. 

243.  Rates.  Brokers  of  securities,  produce,  and  merchandise  $50. 
Brokers  belonging  to  exchanges,  additional  tax,  where  value  of  member¬ 
ship  is  more  than  $2,000  but  less  than  $5,000,  $100 — more  than  $5,000, 
$150.  Pawnbrokers  $100.  Ship  brokers  and  custom  house  brokers  $50. 
Theatres,  museums  and  concert  halls:  seating  capacity  not  over  250, 
$50 — seating  capacity  between  250  and  500,  $100 — between  500  and  800, 
$150 — over  800,  $200 — in  cities,  towns  or  villages  of  population  of  5,000 
or  less,  one  half  of  above  rates.  Circuses,  $100.  Other  exhibitions,  $15; 
street  fairs,  maximum,  $100.  Bowling  alleys  and  billiard  rooms,  for  each 
alley  or  table  $10.  Shooting  galleries  $20.  Riding  academies  $100; 
Sight-seeing  automobiles  seating  from  three  to  seven,  each  $10 — seating 
more  than  seven,  each  $20.  Brewers,  distillers,  liquor  dealers,  and 
manufacturers  of  stills,  carrying  on  business  contrary  to  law  $1,000. 
Use  of  pleasure  boats  taxed  at  double  former  rates,  effective  60  days 
after  passage. 

8.  Soft  Drinks. 

244.  A  new  tax,  effective  May  1,  1919,  is  imposed  upon  the  sale  of 
soft  drinks,  ice  cream,  and  similar  food  or  drink  served  for  consumption 
at  the  place  of  sale.  The  tax  is  1  cent  for  each  10  cents  or  fraction  paid, 
and  is  payable  by  the  purchaser. 

9.  Child.  Labor  Tax. 

245.  A  new  tax  is  imposed  to  discourage  the  employment  of  child 
labor,  amounting  to  10%  of  the  net  proceeds  received  or  accrued  during 
the  taxable  year  from  the  sale  of  the  product  of  (a)  any  mine  or 
quarry  in  which  children  under  the  age  of  16  years  have  been  employed 
or  permitted  to  work  during  any  portion  of  the  year,  or  (b)  of  any 
other  manufacturing  establishment  employing  children  under  14  years 
or  permitting  children  between  14  and  16  to  work  more  than  8  hours  in 
any  day,  or  more  than  6  days  in  any  week,  or  after  7  P.  M.  or  before 
6  A.  M.,  during  any  portion  of  the  year.  The  tax  applies  to  such 
employment  after  sixty  days  after  the  passage  of  the  Act. 

10.  Leasing  Motion  Picture  Films 

246.  In  lieu  of  the  former  excise  taxes,  it  is  now  provided  that  from 
May  1,  1919,  any  person  engaged  in  the  business  of  leasing  positive 
motion  picture  films  for  exhibition  shall  pay  a  monthly  excise  tax  equal 
to  5%  of  the  total  rentals  for  the  preceding  month.  If  a  bona  fide 
contract  made  prior  to  December  6,  1918,  prevents  the  adding  of  the 
whole  of  the  tax  to  the  amount  of  the  rental,  then  the  lessor  or  licensee 
shall  pay  so  much  of  the  tax  as  is  not  added  to  the  contract  price. 


MISCELLANEOUS  WAR  TAXES 


S') 


247.  Schedule. 


11.  Stamp  Taxes. 


Tax. 


Ronds  of  indebtedness,  debentures,  and  certificates  of  indebtedness, 
issued  by  a  person,  partnership,  or  corporation,  when  issued  or  re¬ 
newed,  on  each  $100  of  face  value  or  fraction  thereof . $0.05 

All  other  bonds,  including  indemnity,  surety,  and  penal  bonds, 
policies  of  guaranty  and  fidelity  insurance,  and  title  guaranty 
and  mortgage  guaranty  policies,  but  not  including  bonds  re¬ 


quired  in  legal  proceedings, 

— on  each  $1.00  or  fractional  part  thereof  of  premium  charged . 01 

— if  no  premium  is  charged . 50 


Capital  stock  or  certificates  of  interest  in  profits,  of  association  or 
corporation  when  originally  issued,  in  organization  or  reorganiza¬ 
tion — on  each  $100  of  face  value  or  fraction  thereof  of  each  certi¬ 
ficate — if  no  face  value  on  each  $100  of  actual  value  of  fraction 


thereof  of  each  share . 05 

Sales  or  transfers  of  stock  in  association  or  corporation — on  each 
$100  of  face  value  or  fraction  thereof  of  each  certificate — on  each 
$100  of  actual  value  or  fraction  thereof  of  each  share  without 
face  value  . 02 


Sales  of  products  and  agreements  to  sell,  on  exchanges  and  boards 
of  trade,  for  future  delivery,  for  first  $100  and  for  each  additional 
$100  or  fractional  part  thereof  in  value  of  the  merchandise . 02 

Drafts  or  checks,  payable  otherwise  than  at  sight  or  on  demand,  and 
promissory  notes,  except  bank  notes  issued  for  circulation,  when 
issued  or  renewed,  on  each  $100  or  fractional  part  thereof . 02 

Conveyance  of  real  estate  in  case  of  sale,  on  each  $500,  or  fraction 
thereof,  of  the  consideration  or  value  of  the  interest  conveyed, 

(if  more  than  $100) . 50 

Entry  of  goods  at  custom  house, 

— not  exceeding  $100  in  value . 25 

— exceeding  $100  and  not  exceeding  $500  in  value . 50 

— exceeding  $500  in  value .  1.00 

Entry  for  withdrawal  of  goods  from  customs  bonded  warehouse . 50 

Passage  ticket  bv  vessel  to  a  port  or  place  not  in  the  United  States, 
Canada,  or  Mexico,  sold  or  issued  in  the  United  States,  for  each 
passenger, 

— if  cost  exceeds  $10  but  does  not  exceed  $30 .  LOO 

— if  cost  exceeds  $30  but  does  not  exceed  $00 .  3.00 

— if  cost  exceeds  $80 .  5.00 


Proxy  for  voting  at  election  or  business  meeting  of  a  corporation 

(except  religious,  educational  and  other  exempt  corporations)...  .10 

Power  of  attorney  (except  to  collect  pensions,  etc.,  and  powers  of 
attorney  required  in  bankruptcy  cases) . 25 

Playing  cards,  not  more  than  54  in  pack,  per  pack . OS 

Parcel  post  packages,  for  first,  25c  and  each  addition  25c.  or  fraction 
thereof  charged  . 


.01 


.  I  i. 


jfelaAMMfQV  ««u 

I  .  .  ;1  •;  -  ■■•;>■•*•  « ( 

" 

■ 

i  ,  '•  '  .  ‘  •. 

>•  0  i1-*  • '  * 

.  i d  »i  l.' 

. 

.*  H  <  '  tjftfl.  A  *  .:*•  Jr  «).*•'»! 

>  »;t  x 


ilK*d' 1  ■  /  )  ;t- 


•  **«  . ■  tlitO  ’•  ■  >  .  -  >1  >•'-  ■  • 

>*• '  •  •  t r* •'!  .m*  •/ 


.  ■  ■ 

-  i' 

•  • 

* 

.  . 

■  *>  : 

it ;  j 

!  •  . 

* 

-V  .  .  * 

•  ‘ 

.  : 

J<W  »'fj{  > 

til 

<  •>  * 

K>J 


. 

-  • .  * 


.  .  '  •'  ■  u-.-rH.f 

. 

i  ‘  h  -  J-  ■  •  r.-''-  ! 


..  •  •  -  .  •  .  ■ .  ■  1 

- 


"  • 


.  .  ■  '  ,  -  • 
:  >. 


INDEX 


The  numbers  refer 

The  numbers  refer  to  paragraphs 
Abatement  of  tax,  192 

Accounts  inadequately  kept,  computation 
of  income  illustrated,  205 
Accrual  basis  for  computing  income,  59 
Administrator,  Return  by,  39 
Advertising  costs  as  expense,  155 
Affiliated  corporations,  returns  consolidated, 

32. 

Alimony  not  taxable,  67 
Amended  Returns,  188 

Amortization  of  war  plants,  179;  adjustment 
for  actual  loss,  180 

Anticipated  losses  not  deductible,  181 

Anticipations  and  reserves,  60 

Appraisal  of  property,  effect  on  income,  60; 

effect  on  invested  capital,  50,  217 
Appreciation  of  property,  effect  on  invested 
capital,  50,  217 

Architects’  plaps,  cost  not  deductible,  134 
Assessment  of  tax,  192 
Associations  defined,  21 

Average  invested  capital,  determination 
of,  51 

Hank,  private,  dividends  from.  120 
Rank  stock,  taxes  on,  deductible,  15H 
Basis  for  Return:  receipt  and  accrual,  59; 

calendar  and  fiscal  year,  29,  58,  208 
Board  and  lodging  as  income,  79 
Boards  of  Trade,  exempt,  33 
Bonds;  accrued  interest  apportioned  on  sale. 

115;  exempt  from  tax,  72-77 ;  of  exempt 
corporation,  113;  losses  upon  issue  and 
redemption,  169;  tax  free,  114,  199,  156.  159. 
Bonuses;  as  income,  83;  deductible,  147 
Borrowed  capital,  excluded  from  invested 
capital,  45 

Brands  as  invested  capital,  47 
Brokers,  returns  of  information,  196 
Building  erected  by  tenant,  127,  144 
Building  and  Loan  Association  exempt,  33 
Business  and  casual  activities,  135 
Business  losses  deductible,  162 

Calendar  year  basis,  58 
Capital  Invested,  see  Invested  Capital 
Capital  'Stock;  losses  on  issue  ana  redemp¬ 
tion,  170;  paid-up  stock  as  invested  capi¬ 
tal  43 

Carrying  charges  included  in  cost,  101 
('asli  paid  in,  us  invested  capital,  46 
Cemetery  companies  exempt,  33 
Certificates  of  ownership,  200 
Chambers  of  Commerce,  exempt,  33 
Changes  in  invested  capital  averaged,  51 
Charitable  organizations  exempt,  33 
Charities,  contributions  to,  150,  182 
Charter  of  corporat ion,  cost  not  deductible, 

154 

Chattels,  installment  sales,  88 

City  employees,  compensation  not  taxed,  69 

Clergymen's  fees,  81 

Claim  for  abatement  or  refund,  192 


to  paragraphs 

Closed  transaction  determines  income,  60 
Clubs  exempt,  33 
Collection  of  tax,  192 
Combined  incomes  of  married  persons,  13 
Commissions  as  income,  78 
Comparative  rate  of  profits  tax,  27,  28,  215 
Compensation  for  services,  78;.  for  injuries 
ana  damage,  64  ,  65,  149 
Conservator's  Return,  39 
Consolidation,  invested  capital  of  company 
formed  by,  214;  see  Reorganization 
Consolidated  return,  32 
Constructive  receipt,  61 
Contracting  business,  gross  income,  93 
Contributions  to  campaign  funds,  13  ;  to 
charities,  150,  182 

Co-operative  associations,  exempt,  33 
Co-operative  stores,  distribution  of,  profits 
of,  120 

Copyrights  as  invested  capital,  47;  cost  not 
deductible,  134 

Corporations,  defined,  21;  affiliated,  consol¬ 
idated  Returns  of,  32;  exempt,  33;  fiscal 
year,  58,  29,  208;  information  at  source 
Returns,  195;  new  or  reorganized,  25,  55, 
214;  rate  of  Income  and  Profits  Tax,  22; 
Returns  required,  36;  promotion  trans¬ 
actions,  212;  treasury  stock,  108 
Cost  of  property  defined,  101 ;  not  deductible 
as  expense,  134 

Court  action  for  recovery  of  tax  paid,  192; 

to  prevent  collection,  192 
Credit  for  Excess  Profits  Tax,  23;  for  Income 
Tax,  26;  for  War  Profits  Tax,  24,  25;  for 
dividends,  8;  for  partly  exempt  interest , 
8;  for  losses  of  another  year,  165;  for  foreign 
taxes,  160 

Crop  Shares  as  income,  127 
Customs  duties,  158 

Damages,  compensation  for,  64,  65 
Debts,  payment  or  release  not  income,  131; 

charged  off  as  worthless,  167 
Deceased  person,  Return  for,  17,  40;  exemp¬ 
tions,  17 

Deductions  from  gross  income,  132-182;  of 
farmers,  94 

Dependents,  exemption  for,  7,  12 
Depletion  of  natural  resources,  181,  210 
Depreciation,  171-178;  effect  on  invested 
capital,  50,  216;  effect  on  loss,  164;  deter¬ 
mination  of  allowance,  175,  209;  rates,  176; 
relation  to  repairs,  177,  151;  of  patents,  178. 
Development  expense,  155 
Discarded  property  as  loss,  164 
Distributions  other  than  dividends,  120 
Dividends  as  income,  116-126;  defined,  117; 
when  not  taxed,  8,  68,  1 18;  on  life  insurance 
policy,  66,  125;  as  reduction  of  invested 
capital,  52;  personal  service  corporations, 
123;  receipt  date  fixes  the  tax,  119;  special 
forms,  120;  stock  dividends,  117,  122;  taxa¬ 
tion  illustrated,  121 
Domestic’s  wages  not  deductible,  133 


INDEX 


The  numbers  refer  to  paragraphs 


Donations  of  corporations,  150;  of  indi¬ 
viduals  and  estates,  182 

Education  of  children,  expense  not  deducti¬ 
ble,  133 

Educational  organizations  exempt,  33 
Estates,  taxation  of,  38;  expenses  of,  145 
Excess  Profits  Tax,  definition  and  rates,  22; 
credit  for,  23 

Exchange  of  property,  profit  or  loss  upon, 
103,  109,  110,  211 

Excise  taxes,  when  deductible,  158 
Executor’s  Return,  39 
Exempt  corporations  and  associations,  33 
Exempt  income,  62-77 

Exemptions  of  individuals,  7 ;  deceased  and 
surviving  spouse,  17;  for  dependents,  7; 
married  persons,  7,  14;  single  person,  7; 
status  at  end  of  year  determines,  18;  non¬ 
resident  alien,  20. 

Exemptions  of  corporations,  23-26 
Exhaustion  of  property,  171,  181,  210 
Expenses  of  business,  132-155;  defined,  132; 
unnecessary  and  unreasonable,  136;  of 
development,  155;  of  estates,  145;  of  farm¬ 
ers,  142;  of  landlord  and  tenant,  144;  of 
manufacturing  business,  141;  of  mercan¬ 
tile  business,  138;  of  organizing,  154; 
of  salaried  employee,  143;  paid  or  incurred, 
137;  personal  and  family  expenses,  133 
Experiment,  expense  of,  155 

False  Returns,  penalty,  187 
Family  corporation  not  exempt,  35 
Family  expenses  not  deductible,  133 
Farmer,  expenses,  142;  gross  income,  94,  79; 

inventory,  142;  illustration,  204. 

Federal  Farm  Loan  Act,  exemptions,  33,  76 
Federal  Reserve  Bank  stock,  dividends 
exempt,  76 

Fees  as  income,  78,  203 

Fiduciaries,  defined,  39;  income  of,  129; 
income  received  from,  129;  Returns  and 
tax  of,  39,  129;  Return  as  agent,  40 
Filing  of  Returns,  183-186 
Fire  insurance  premiums,  when  deductible, 
153 

Fiscal  year  basis  for  Return,  58;  rate  adjust¬ 
ment,  29;  illustrated,  208;  partnership 
income,  128 

Foreign  corporations,  37,  198 
Foreign  government  bonds,  interest  not 
exempt,  75 

Foreign  interest  and  dividends,  information 
at  source,  197 
Foreign  Taxes,  160 
Franchise,  cost  of,  154 
Fraternal  societies  exempt,  33 

Gambling  gains,  130 
Gifts  not  income,  83;  taxed  at  sale,  104 
Gold  mining,  income  from,  exempt  from 
profits  tax,  71 

Good  will,  as  invested  capital,  47,  49;  shrink¬ 
age  in  value  of,  173;  sale  of,  109 


Government  bonds,  state  and  municipal, 
73;  federal,  72;  inadmissible  assets,  53 
Government  contracts,  income  from,  de¬ 
fined,  96;  rates  of  1918  extended,  22;  effect 
on  War  Profits  credit,  25;  effect  on  claim 
for  comparative  rate  of  Profits  Tax,  28; 
personal  service  corporation,  30;  affiliated 
corporations,  32 

Gratuities  and  tips  as  income,  82 
Gross  Income  denned,  57;  items  excluded, 
62-77;  particular  items  of,  78-131 
Guardian,  Return  of,  39 

Head  of  family  defined,  12;  exemption  of,  7 
Hotel  bills,  when  deductible,  133,  143 
Husband  and  Wife,  exemption,  7,  14;  joint, 
returns,  13,  15;  illustration,  16 

Improvements,  permanent,  134 
Inadequate  bookkeeping,  computation  of 
income,  illustrated,  205 
Inadmissible  assets  defined,  53;  deduction 
for,  54 

Incidental  benefits  as  income,  79 
Income  defined,  56 

Incorporation  retroactively  effective,  31 
Information  at  source,  by  broker,  196;  by 
corporation,  195;  foreign  interest  anil 
dividends,  197;  payments  of  $1,000  in  year, 
194;  Returns  of,  193 
Inheritance  taxes,  not  deductible,  158 
Installment  sales,  personal  property,  86,  87, 
91,  92;  real  estate,  88-92 
Insurance  companies,  gross  income,  95 
Insurance  policies,  proceeds  of,  66,  64. 
Insurance  premiums,  fire,  153;  life,  152 
Intangible  property  as  invested  capital,  47 
Interest,  received  or  accrued,  112;  exempt 
interest,  72-77;  paid  or  accrued,  156;  on 
indebtedness  to  carry  tax  exempt  securi¬ 
ties,  157;  on  tax  free  bonds,  114,  156 
Inventory,  basis  required,  140;  of  farmer, 
142;  shrinkage  in  value  of,  164,  166 
Invested  capital  defined,  42;  determination 
of,  43-55;  illustrated,  212,  213,  214,  216,  217; 
average  determined,  51;  appreciation  in 
value  of  property  disregarded,  50;  cash 
paid  in,  46;  consolidated  Return  of,  32; 
change  during  year,  51;  copyrights  as,  47; 
effect  of  depreciation,  50;  dividend  as 
reduction,  52;  good  will  as,  47, 49;  inadmis¬ 
sible  assets,  53,  54;  “mixed  aggregate”  of 
assets,  49;  intangible  property,  47,  49; 
paid-up  stock,  43;  patents  as,  47;  reor¬ 
ganized  business,  55,  214;  surplus,  earned 
and  paid-in,  44;  tangible  property,  47,  213; 
tax  exempt  securities  as,  53;  undivided 
profits,  44 

Landlord  and  tenant,  expenses  of,  144,  174, 
202,  213;  income  of.  127,  202 
Leasehold  as  invested  capital,  213 
Legacies  paid,  not  income,  63,  129 
Legislation,  1919,  and  prior  laws,  2 


INDEX 


The  uutubers  refer  to  paragraphs 


Liberty  Bonds,  interest  on,  72;  as  invested 
capital,  53;  interest  paid  to  carry,  157 
License  fees,  when  deductible,  158 
Life  insurance  companies,  gross  income,  95 
Life  insurance  policy,  proceeds  of,  66; 

premiums  on,  153;  dividends  on,  125 
Life  insurance  premiums,  when  deductible, 


153 


.imited  partnership, 
taxed,  120 


tax  of,  21;  dividends 


Limitation  upon  actions  to  collect  or  recover 

tax,  192 

Living  expenses  not  deductible,  133 
lobbying  expense  not  deductible,  135 
losses,  deduction  of,  161-170;  defined,  60, 
111;  accrued  before  March  1,  1913,  163; 
amortization  of,  179;  anticipated,  60,  161, 
172;  bad  debts  and  accounts,  162;  bonds 
issued  or  redeemed,  169;  in  business,  162; 
capital  stock  issued  or  redeemed,  170; 
credit  for  those  of  another  year,  165; 
depreciation,  171;  depletion,  181;  on  in¬ 
ventory  values,  166;  obsolescence,  172,  164; 
property  damaged  or  discarded,  164; 
reserves  for,  60;  sales,  163;  on  securities, 
168,  211;  transactions  not  connected  with 
business,  162 


Machinery,  cost  of,  not  deductible,  134 
Manufacturing  business,  gross  income  of, 
85;  expenses  of,  141. 

Market  price,  in  inventories,  140;  determina¬ 
tion  of,  100;  used  to  determine  profit,  99 
Married  persous,  exemptions,  7,  14;  Returns 

of,  11.  13 

Married  woman’s  Return,  15 
Massachusetts  Trusts,  21 
Mercantile  business,  gross  income  of,  85; 
expenses  of,  138 

Mines,  income  from,  71 ;  depletion  allowance, 

181 

Minors,  income  and  Returns  of,  19;  salaries 
not  deductible  by  parents,  148. 

Mixed  Aggregate  of  assets  as  invested 

capital,  49 

Municipal  and  state  bonds,  exempt,  73; 

inadmissible  assets,  53 
Municipal  employees,  compensation  not 

taxed,  69 

Mutual  savings  bank;  exempt,  33 
Net  Income  defined,  57 

Nonresident  aliens,  20;  payment  at  source, 

198 

Normal  Tax,  definition  and  rate,  9 


Obsolescence,  anticipated,  172;  losses  result¬ 
ing  from,  164 

Oil  and  gas  wells,  depletion  allowance,  181; 
profit  upon  sale  of,  71 

Organization  exj>enses  not  deductible,  134 

154.  176 

Ostensible  salaries  as  income,  84;  as  expense, 

146 


Raid-in  cash  as  invested  capital,  43,  44.  46 
Paid-up  capital  stock  as  invested  capital.  43 
Partnership,  members  only  taxed,  128; 

profits  as  income,  128;  Returns,  41 
Patents  as  invested  capital,  47;  depreciation. 
178 

Payment  and  accrual  basis,  59,  137,  156,  153 
Payment  of  tax,  time  of,  189;  cash  or  check 
190;  penalties  for  delinquency,  191 
Payment  at  source:  foreign  corporations,  37, 
198;  nonresident  aliens,  20,  198;  tax-free 
bonds,  199;  Returns  of,  198 
Penalties:  false  Return,  187;  delinquent 
Return,  .183;  delinquent  payment,  191; 
understatement  in  Return.  187 
Pensions  and  pension  funds  as  income,  80; 
deductible,  149 

Permanent  improvements,  cost  not  de¬ 
ductible,  134 

Permit  fees,  when  deductible,  158 
Personal  exemption,  7 
Personal  expenses  not  deductible,  133 
Personal  injuries  compensation  for,  64; 
payments  for,  149 

Personal  service  corporations  defined.  30; 

how  taxed,  30;  dividends  from,  123 
Persons  subject  to  tax,  6 
Premiums  paid,  when  deductible,  152,  153, 
169,  170 

Professional  income,  78,  203 
Profit  on  sale  of  property  is  income,  97-111; 
defined  98;  determination  of  101-103: 
“paper  profits,”  98;  on  property  exchanged 
103;  on  stocks  and  securities,  106,  107,  110, 
211;  on  mines  and  oil  wells,  71 ;  taxed  only 
when  realized,  60 

Profits  of  corporation,  distributed  as  salaries, 

84 

Profits  of  partnership,  128;  of  personal  serv¬ 
ice  corporation,  30,  123;  illegal,  130 
Property  damage,  compensation  for,  65 
Public  utilities  securities,  interest  not 
exempt,  74 

Rate,  individual  tax,  9,  10;  corporation 
tax,  22;  adjustment  between  calendar  and 
fiscal  year,  29,  208;  comparative  rate  for 
Profits  Tax,  27,  28,  215; 

Real  estate,  installment  sales,  88-92;  sub¬ 
division,  90 
Realized  profit,  60,  98 

Receipt  basis  for  computing  income,  59,  61 
Receiver’s  Return,  39 
Refund  of  tax  paid,  192 
Rejected  Returns,  188 
Religious  organizations  exempt,  33 
Renewals  as  expense,  151 
Rent  as  income,  79,  127;  as  expense,  144 
Reorganization,  exchange  of  securities  upon, 
110,  211;  effect  on  invested  capital,  55,  214, 
effect  on  War  Profits  credit,  25 
Repairs  as  expense,  *151;  by  tenant  as 
expense,  144;  relation  to  depreciation,  177 
Replacement  as  expense,  151 
Repossession  of  property  as  income,  92 


INDEX 


The  numbers  refer  to  paragraphs 


Reserves  not  deductible,  (30 
Returns  required,  11.  36,  193-198;  time  of 
filing,  183;  amended,  188;  by  agent  for 
incapacitated  person,  186;  false  or  incor¬ 
rect,  penalty  for,  187;  place  of  filing,  185; 
of  corporations,  36;  of  fiduciaries,  39;  of 
information  at  source,  193;  of  partnership, 
41;  rejected,  188;  understatement  in,  187 
Royalties  as  income,  127 
Rulings  of  Treasury  Department,  nature 
and  effect,  34 

Salaries  as  income,  78;  as  expense,  146;  con¬ 
tingent  amount,  147;  of  city,’  state,  etc., 
employees,  69;  of  soldiers  and  sailors,  70; 
of  minors,  148;  including  incidental  bene¬ 
fits,  79;  deductions  from,  143 
Sale  of  gift,  profit  on,  104;  of  property,  97-111, 
163;  of  securities,  105;  determination  of 
selling  price,  102 

Salvage  value,  recognition  of,  134,  164,  175 
Securities,  exempt  interest  on,  72-77;  sale  of, 
105,  106,  168;  exchange  of,  110,  211;  as  in¬ 
vested  capital,  48,  53 
Selling  price,  102 
Shrinkage  in  vaiue  60,  161,  173 
Single  person,  exempt  ion, 7  ;  Return  required, 

if 

Special  assessment  not  deductible,  158 
Stamp  taxes,  when  deductible,  158 
State  employees,  compensation  not  taxed,  69 
Stock,  exchanged  for  other  issues,  110,  211; 

profit  and  loss  on,  105,  106,  168 
Stock  dividends  defined,  117;  effect  on  cost, 
111;  whether  taxable,  122; 

Suit  for  recovery  of  taxes  paid,  192 
Surplus,  paid-in  or  earned,  as  invested  capi¬ 
tal,  44 

Surtax,  definition  and  rate,  10 
Tangible  property  as  invested  capital,  47, 
213 


Taxes,  when  deductible,  158-160 
Tax-free  bonds,  interest  on,  114,  156;  pay¬ 
ment  at  source,  199;  deduction  of  ti\ 
paid,  156,  159;  credit  for  tax  paid,  114,  206 
Timber,  depletion  allowance,  181,  210 
Time  of  payment,  189 
Tips  and  gratuities  as  income,  82 
Tools  and  implements, when  cost  deductible, 
134 

Trade  losses,  162 

Trade  marks  as  invested  capital,  47 
Traveling  expenses,  143 
Treasury  stock,  108,  212 
Trustee’s  Return,  39 

Understatement  in  Return,  effect  of,  187 
Undistributed  profits  unreasonably  ac¬ 
cumulated,  124 

Undivided  profits  as  invested  capital,  44 
Uniforms  of  employees  as  expense,  143 
United  States  bonds,  interest  on,  72;  as 
invested  capital,  53 

Value  as  of  March  1,  1913,  determinatiou,  99, 
100 


Wages  as  income,  78 

War  Finance  Corporation  bonds,  interest 
on,  77 

War  plants,  amortization  of  cost,  179 
War  Profits  credit,  24;  of  new  or  reorganize  I 
business,  25 

War  Profits  Tax,  nature  of,  22; 

Water  taxes,  158 
Wear  and  tear  of  property,  171 
Withholding  at  source  on  “tax  free”  bonds, 
114,  199;  nonresident  aliens  and  foreign 
corporations,  20,  37,  198 
Wortldess  debts,  162,  167 


* 


■ 


* 


Date  Due 


.!!|f  i  r 

uUU  ]  u  1  | 

\ 

• 

> 

<$> 

- 

HALSEY,  STUART  &  CO. 

INCORPORATED — SUCCESSORS  TO 

N.  W.  HALSEY  &  CO.,  CHICAGO 

are  in  a  position  at  all  times  to  submit  offerings  suitable 
for  the  investments  of  individual  investors,  banks, 

n- 

v- 

3^f  /  € 

Bapst  Library 

Boston  College  ** 

Chestnut  Hill,  Mass.  02167 

or 

of 

nt 

to 

V  * 

0 

4 

rtT  Ufe  S' 2"  : 

W  SAFE  BONDS  FOR  INVESTMENT 
$1,000  $500  $100 


. 


I 

r 


r* 

w‘ 


r  f  ' 

k  -  ^  f 


» 


.v 


i 


